Ignore the sophistry, the middle class picks up a predominant share of the nation's taxes

The government recently released time-series data on income tax. While much of the data was known, it sparked off renewed debates on the level of taxation, the small numbers of people paying taxes, adequacy of our tax rates etc. The junior minister of Finance, Jayant Sinha weighed in on the debate in an interaction with journalists/economists, hosted by Swarajyamag. He made a few key observations, some of which merit closer scrutiny.

1. The number of people filing tax-returns isnt as low as the headline number (~4.5 crores) suggests, its a reasonably fair reflection of our economic structure.

2. Levels of tax-rates in India are "moderate", lower than rest of the comparable world.

3. Most importantly, its a mistaken notion that the middle class takes up a disproportionate part of the tax burden, as 50% of the taxes are indirect taxes (that impact all, poor disproportionately), and income tax-to-GDP ratio is only ~22%.

Well, banality of headline numbers is de rigeur with politicians, but one expected somewhat better from Jayant Sinha, with his significant experience in money management. He is right on the first point, ie, the number of tax-payers, once adjusted for agricultural income (and bracketed up on households), is a respectable number. Unfortunately thats where the good analysis ends. 

Firstly,tax rates. The minister would have us believe that India is a "moderate tax" country with peak tax rate @ ~35%, lower than most comparable ones. The examples he quotes? US (25 times our percapita income), UK (20 times).  For good measure of comparability, he quotes China's 45% peak tax rate, forgetting perhaps that China's per capita income is 4.5 times India's! 

Comparing more comparably, India's peak income tax rates are at the upper end of Asian levels. From 25% levels in Malaysia/Sri Lanka to 35% in Vietnam/Thailand, Indian peak tax-rates are more than fair in the context of our geography and per capita income.

In a breathtaking instance of a  bizarre non-sequitur, the minister added that countries like Singapore have low tax rates because they dont have an army! For a government thin on academic talent, Jayant Sinha is an exception, hence its doubly surprising how he missed that Singapore one of the highest defence-to-GDP ratios in Asia!

Now to the contribution of the "middle class" to the overall tax collections of the government. the central government's tax pie looks something like this.

Tax head	INR Crores	% contribution to total
Income Tax	353,173	22%
Corporate Tax	493,923	30%
Excise	318,669	20%
Customs	230,000	14%
Service Tax	231,000	14%

Source: Union Budget 2016-17

Again, banality of the headline number strikes. Only 22% of total central taxes is contributed by income tax. another ~30% is corporate tax, and the balance, a disproportionate (by global standards) 50% is from indirect taxes. Indirect taxes ostensibly are regressive, as has non-linear, asymmetric impact on household incomes (in other words, poorer you are, greater is the impact of the tax levied for buying the same packet of cigarette).

But as usual, the headline number masks the reality.

There are three major components of indirect taxes today are Excise, Customs and Service taxes.

A CAG report from 2013 has good data on the contribution of various commodities and service categories towards excise and service taxes. It is clear from data that indirect taxes, to a large extent, and directed primarily at the "Middle Class", and while not being as progressive in nature as income taxes, are largely borne by the 120-150 million folks that comprise the middle class of India. Lets call this the "Middle Class Tax", or MCT.

To start with, ~50% of all excise taxes are due to petroleum products, primarily petrol and diesel. In other words, ~10% of Excise taxes come from motor fuels. Petrol comprises ~18% of the motor fuel mix, while diesel comprises 82%. As per AC Nielsen, around 13% of all diesel sales, and 100% of all petrol sales are accounted for by private cars and 2-wheelers. Through elementary maths, this means that ~30% of all motor fuel taxes (or 15% of excise taxes = 30%X50%) can be classified as MCT.

Second, Motor vehicles contribute 6% to the central excise kitty - another tax that can be entirely classified as MCT (given that vehicle ownership is termed by politicians to be a "middle class luxury").

Third, service taxes. Its the fastest growing head of tax revenues, and every year new categories of services are included in its ambit. What are the key categories contributing to this kitty today? Check carefully the components (from the same CAG report referenced above). Financial services, restaurants, telecoms, business auxiliary services, insurance premia, construction&renting of property, maintenance & repairs - in short, barrign a few its mostly a laundry list of services consumed in large quantities essentially by the Middle Class. While its somewhat tough to put a precise number, going by the contributing category heads, it would be safe to assume a 60% contribution of MCT in the service tax kitty, in other words, ~8.4% of aggregate central taxes.

Last, customs taxes. Bulk of the contribution to customs come in from industrial intermediates and capital goods. From pure value terms, it would be difficult to directly attribute a progressive direct burden on the middle class alone from these levies. Hence, it would be fair to take a 0% MCT on the same.

Net net, therefore, how does it look?

Tax head	INR Crores	% contribution to total	MCT contribution
Income Tax	353,173	22%	100%
Corporate Tax	493,923	30%	0%
Excise	318,669	20%	21%
Customs	230,000	14%	0%
Service Tax	231,000	14%	60%
			34%

In other words, MCT accounts for 34% of ALL central taxes directly. This isnt accounting for the share of unattributeable indirect taxes as well as local/state taxes that are contributed by the middle class.

Safe to say that the middle class bears a much larger than its fair share of the nation's taxes, while encountering a tax rate that is at the upper end of Asian levels, and a tax administration that is at the lowest end of the same levels!

A data-challenged minister shouldnt get away with saying anything else!

Indian Mutual Funds - Rising tides raise the ship, fails to hide the rotten hull

Recently, Nilesh Shah, a respected veteran of the industry (and CEO, Kotak Mutual Fund) wondered aloud in a tweet why share of MFs in national financial savings remains low (lower than even cash in the hands/below the pillows of public). For an industry that was meant to be one of the sunrise sectors of the new millennium has been basically been a par beneficiary of growth. Long term trend numbers are impressive, but merely in line with the impressive GDP numbers, and an increase in the level of financial savings in the economy, especially by households.

There were three major verticals in the financial sector opened up for private participation in the first flush of liberalisation  - Banks (1994), Insurance (1999) and Mutual Funds (1993). The results have been illustrative.




Barring a couple of blips (1992, 1999 and 2008), when the share of MFs (and other capital market instruments) touched 9-10% of financial savings, the average (mean as well as median) share has hovered around the 4-5% level. This despite a headstart in terms of private sector participation, significant tax advantages (that continue till date) over other financial instruments and the ready playing arena of a well developed equity capital market. Bank deposits continue their dominant (nearly half) share, while Insurance has steadily gained marketshare from other instruments.

The reasons for this are manifold, with some having become cliches that are repeated ad nauseam. Pensions are the biggest one, parroted out during every discussion. While its a legitimate point, it begs the question though what initiative asset managers have shown since 2003 (the year pensions were opened for private sector) to expand the pensions market. Regulatory progress has been admittedly patchy, but the number of bright sparks from the industry can be compared to those from diwali crackers in Iceland!

In general, the problem is a financial equivalence of the oil curse. So comfortable has the industry been on large, significant tax-breaks on its products (Interest on a bond is taxable at marginal income tax rate, but the same interest paid as capital gains in a MF is taxed at a lower rate. Selling unlisted equity attracts capital gains tax, selling close-ended Equity MFs attract no tax!).

A perverse outcome of the above has been the concentration of institutional and corporate treasury money in MF AUMs. As of Dec 2015,  close to 50% of the AUMs came from Corporates, Banks and Institutions. In other words, the actual share of MFs in household financial savings is half of the topline number shown in the chart above.

Second, complete lack of innovation. The last big bright idea was creation of differentiated share classes (through institutional plans) in 2003/4. Since then, the biggest ideas have been around fees - either on ways of reducing it or packaging products to extract more of it. For an industry that is so new, the commoditisation (reflected on fees being the primary discussion point) has come in rather fast!

Third and last, lack of disruptive technology interventions of the sort that we have seen in banking. This admittedly isnt entirely an Asset Manager issue, but lack of imagination from the MF industry has been stark.

Most developed financial markets have large Mutual Funds shaping opinions and steering savings in risky assets. Lack of adequate movement in India has led to policy-makers and investors looking for alternative vehicles (note AIF guidelines allowing investments in public market instruments, note the discussion around Wholesale Banks). Just as India risks missing the manufacturing age, MFs risk being bypassed while financial savings find alternate routes to feeding risk capital.

Pak JIT to visit Pathankot AFB - Modi's "Jaswant" moment?

For a government that has been generally pilloried for not being "radical" enough in its policy interventions, the Modi government has lately shown a strange penchant for spending an enormous amount of political capital on small impact initiatives.

The latest of them is the visit of the Pak JIT to India to investigate the Pathankot AFB terror attack. to be sure, this isnt unprecedented, there was a Pakistani Judicial Commission that visited India in 2012 to record the testimony of witnesses. But there are key differences between 2012 and 2016. For one, the composition of the Pak team - this time, it consists purely of police/intelligence officials, including a junior officer of the ISI. But more intriguingly, its the access accorded to the team that is curious. The Pak team will visit Pathankot AFB, though it has been said that they would not be allowed inside the "Technical area" (the part of the AFB that houses aircraft and missile/radar systems). Somewhat facetiously this would be the first time an ISI (and a MI) officer would "officially" set foot inside an Indian AFB.

What isnt quite clear is the purpose of the visit. All terrorists involved in the attack have been killed. The terror scene would have been cleaned up two months after the incident to afford any great forensic work. Witnesses, barring the Punjab Police SP Salwinder Singh (and his two associates) whose car was ostensibly hijacked by the terrorists, most others would be basically "victims" of the attack and personnel posted in the AFB. By definition they wont have much value to add about the Pakistan connection of the attack, which is the purported objective of the visit.

Question therefore is, what is it that the Pakistani team will do that could not have been done over electronic means in terms of data sharing? Or is it just optics to keep the pressure on Pakistan?

Whatever it is, odds are that this would have an outcome not much different from what has been seen in 26/11. JeM, while not being as strategic an asset for the Pak establishment as LeT is, is still too valuable to be given up on a platter. Not when the establishment thinks that it has substantial strategic leverage thanks to China (CPEC deal) and the upcoming US withdrawal from Afghanistan. Especially as there is no quid pro quo on the table from India, either on Kashmir or for that matter on Afghanistan.

For the Narendra Modi govt, this could end up uncannily like IC814, Jaswant Singh escorting the JeM chief Masood Azhar (and two others) to Afghanistan. It was an imagery (of a culmination of bad strategic choices, starting from Lahore bus yatra) that BJP has been hard pressed to live down. As the hardline nationalist party, the BJP has a certain amount of political leeway in making concessions on Pakistan. But optics without tangible outcomes come back to bite hard.

JeM/Masood Azhar seems to be a case of deja vu for the BJP!

Small Savings rate cuts - How to lose friends and make daft policy

Dogma plays an important role in both politics and economics. After all both are inexact sciences (latter more than the former), hence value of data is always secondary to the primacy of dogma.

Even granting for that though, the decision by the Modi government yesterday to reduce administered interest rates on small savings defies all logic. One, it alienates a core constituency of the BJP, the urban middle class, that was already chaffing at the margins for the Union Budget gaffe on EPF taxation (hastily rescinded). Two, it doesnt even make sense from a purist, macroeconomic standpoint!

Lets go through the market fundamentalist view of why small savings rates needed to come down. The view is simple - as long as households (in other words middle class folks with some disposable income) have alternative savings instruments in the form of PPF/NSC (and other small savings products) with high tax-free interest rates, banks would not be able reduce interest rates on their deposits. So while RBI could cut policy rates, the ability of banks to pass those rates on to borrowers would be circumscribed by the fact that they face unfair competition for deposits in the form of small savings with high interest rates.

Like most market fundamentalist dogmas, the hypothesis doesnt stand basic empirical scrutiny. Lets look at the data on household financial savings in India. Over the last few years, household financial savings have been hovering around the 10% of GDP mark. And they get deployed in a variety of instruments - Bank deposits, shares, Life Insurance, PF, and Small Savings. Look at the composition below.



The numbers are self explanatory. Bank deposits account for a massive 48% of all savings deployed by households in financial assets. Where is that big "transmission roadblock" culprit, Small Savings? Well, its consolidated in the section Claims on Government. And its marketshare? 5.6%! ALL the other components of household financial savings - deposits, insurance, pensions, shares, UTI - are subject to market determined interest rates.

In other words, a small implicit subsidy in 5% of the flows prevents rate cut transmission in 95% of the flows!

This is a classic example of tilting at windmills and brandishing a reformist sword - unfortunately, the financial Don Quixotes have impact far exceeding the spanish dilettante!

Lets also go further and examine the other point - what about the cost to the government of such largesse (towards small savings scheme). The latest Economic Survey has the data.


As can be seen, interest rate subsidy on PPF (the largest, and ostensibly the "unfairest" component of small savings), is ~12000 crores. The other small savings products (PO savings, KVC etc) are used to fund state government deficits, and hence the interest is serviced  by state governments. Lets say that the subsidy on account of all other small savings product is a similar amount. So the total subsidy on account of administered interest rates is ~24000 crores.

For a country with zero social security, is that a big number for rudimentary safety net? In terms of fiscal impact, the notional loss to the government on account of corporate tax exemptions add up to nearly 6 lac crores.

Its clear therefore that purely from an economics standpoint, the reduction of rates on small savings doesnt stand up to basic scrutiny. It seems to be a case of the government giving in to a "financial market populist" demand. However, the political cost of this far outstrips any benefit on the monetary side. For a government that has been so cautious about anything radical, this is a classical "penny wise pound foolish".

One Rank One Pension: Its impact on the defence budget

Published as an Issue Brief by the Observer Research Foundation (ORF)

http://www.orfonline.org/research/one-rank-one-pension-its-impact-on-the-defence-budget/

The One Rank One Pension (OROP) scheme will pay a uniform pension to armed forces personnel, who retire with the same rank after the same length of service, regardless of their date of retirement. It has quickly become one of the most politicised of all military issues in the country today, which may be called odd, given that the political class rarely takes interest in matters related to the military. Indeed, the debate over OROP, ostensibly an employee-benefit programme, has become a leitmotif of all that is wrong with the nation's treatment of the military. Lost in the political din, however, is the key question of affordability. Not being discussed either are questions on long-pending structural reforms in the military, on issues like officer shortages and the need for modernisation. This paper examines the potential impact of OROP on the nation's coffers.

Pathankot - operational win, narrative defeat?

The country has been seized of the audacious terror strike on IAF's Pathankot base for the last few days. The general media (and "expert") analyses seems to be converging around describing the operation as a disaster, with the consensus view being that this is as much of a fiasco operationally (though not in terms of casualties) as Mumbai 26/11.

As an armchair enthusiast, I find the above conclusion a bit puzzling. First up, what would have been the objectives of the folks that planned and executed this fidayeen attack?

1. Spring a surprise attack on a high profile military target to highlight India's vulnerabilities to such jihadi assaults.
2. Destroy aircraft and military assets, if possible.
3. Take hostages to prolong the operation and inflict large casualties, both military and civilian.
4. Perhaps most importantly, capture the media narrative.

So from the perspective of the jihadi groups, how did the outcomes stack up?

1. The attack wasnt a surprise, there was advance intelligence, and forces were waiting for them (even if the specific target wasnt known).
2. No military asset was destroyed. Indeed, IAF aircraft from the air base made repeated sorties in support of the operation. In other words the offensive capacity of the airbase was maintained while the terror attack was on.
3. No hostages were taken, no civilians were killed. Military casualties were high, and something that perhaps could have been minimised.
4. This was the success. The attack and its aftermath has surely captured the media narrative, and shaped it in the direction that the jihadis would have liked.

Tactically therefore, how was the operation a "failure", given that we denied the jihadis most of the desired tactical objectives? It would be interesting to compare this with a very similar incident, where an airbase was attacked with pretty much similar objectives. This was the Taliban attack on Camp Bastion. Camp Bastion is one of the largest coalition logistics and offensive air support base in Afghanistan, situated in the frontier Helmand province. During the attack, it housed a fleet of US Marine Corps (USMC) Harrier fighter aircraft, besides transport aircraft and choppers. Brief summary of the attack in the link below.

https://en.wikipedia.org/wiki/September_2012_Camp_Bastion_raid

In short, the attack managed to destroy or damage 9 aircraft, including 8 Harrier fighters. While military casualties were low (2 killed), the tactical success for the Taliban was huge. And this despite the fact that Bastion, unlike Pathankot was not a family station, and hence housed only combat and support troops (not large numbers of civilians that slow down operations and increase risk of casualties).

While intelligence on an impending attack was much less specific for Bastion than it was for Pathankot, it was a military base in a combat zone (and hence always expecting to be attacked and therefore on hair trigger alert all the time).

It seems where we have lost out is on the media narrative. Seems as if we have managed to achieve in the media for the jihadis that they couldnt in the attack itself. The focus of the media narrative has been on blaming NSA, caviling over choice of forces (NSG versus Army) etc. Its important to control the media narrative in asymmetric conflict, and we seem to have a long way to go. Not just for the government, but for us collectively as a society.

Net Neutrality - regulatory confusion leading to faux debate?

"Net neutrality" has been trending in the social media for quite some time. Thanks to Facebook's aggressive courting of even the main stream media in the last few weeks (with full page ads, Op-eds by Mark Zuckerberg himself et al), the matter has suddenly acquired an even higher profile. As is usually the case with anything digital, acronyms and jargons have taken over the discourse - data discrimination, Freebasic.

It would be useful to look at what the issue really is, and which side of the divide makes more sense.

As of today, access to internet requires subscription to a data plan from a telecom company (telco). Data plans typically are more expensive than vanilla voice plans, though the pricing has been coming off steadily.What Facebook is proposing in partnership with Reliance Communication (RCom) is a "limited access" concept. In this, accessing FB will be free, ie, a subscriber without a data plan would be able to access FB. According to FB (and others on its side of the debate) argue is that this would enhance internet access to people who cannot afford expensive data plans. FB claims that this would increase the pace of internet penetration in India by 50%.

Naysayers on the other hand have two basic objections. One, it violates the concept of "net neutrality", ie, all internet sites should be equally accessible. And two, free FB messenger (say) through RCom will restrict growth of newer, disruptive messenger apps as both FB and RCom would/could act as gatekeepers preventing access to the latter through expensive data. Andy Mukherjee, the Bloomberg columnist has weighed in with the objections quite well in a Livemint article today.

http://www.livemint.com/Opinion/elkKQzTLVAru6wKc44OUMN/Mark-Zuckerbergs-Internet-gift-to-India-looks-like-a-trap.html

I think the issues are twofold.

The first is a philosophical question. And that is simply whether data (internet) is a free commons (like air, sunlight) or a scarce natural resource (like coal, oil). The fact is that the decision on this question has already been taken. Bandwidth has been defined as a natural resource and the government auctions the same for a lot of money. Given the general acceptance of this approach, the society wants to treat internet as commercial consumer service.

The second question therefore is, what should be the regulatory approach towards this service? Coverage, or neutrality? to me its a faux divide.Taking instance from other utility and consumer services, the evidence is actually very strong in favour of differential pricing strategies (of the type advocated by FB) leading to enhanced coverage. Even utilities that are natural monopolies like power distribution, have expanded coverage through differential tariffs. On the other hand, utilities subject to intense competition have shown even better results. None better than telcos on voice telephony, where differential tariffs based on user groups, specific services (like toll free), usage duration and a lot more have made telephony cheaper and enormously helped coverage.

The scenario today is the following - when I surf www, whether I log on to FB or Google or MSN, I pay as per my data plan. A chap who cant afford the data plan is not on www today. Tomorrow, my telco would offer a plan that would make accessing FB free. Will that increase my time on FB? Very unlikely. But that certainly would pull the other chap into www, even if only for FB (and such other "sponsored" sites). Will that increase data tariffs on X-subsidisation? Given the intense competition in the space, virtually unlikely.

Which brings us to the question of neutrality, or access. That is NOT a commercial question, left to RCom or FB. That is a regulatory responsibility. As long as the regulator ensures that RCom is obliged to provide me as speedy an access to MSN messenger as it does to FB messenger, even if it is for a price, anything else doesnt matter. New apps will have the same opportunity to disrupt FB from the "paying customer" population that they have today. Technically, the free internet users accessing FB arent even a customer base for anyone today, hence net net (as they say in banking), it doesnt matter.

This leaves a last, somewhat disturbing point to address. And that is a fear that somehow free access to some sites/apps will "hook" the poor to the internet, and they will start spending money on other, "non-free" sites/apps to their own detriment. This betrays a liberal condescension for the ability of poor to make rational judgements. Not very different from saying that if you give the poor money (instead of subsidy) they will blow it up on alcohol and marriages. As an axiom, this has been debunked time and again (Esther Duflo/Abhijit Banerjee's Poor Economics is a good source of the data).

We should not let class divides come in the way of digital inclusion and exacerbate the digital divide.