Taxes, Political Gridlock, and India’s 2012 Budget: The Future of Economic Policy in India

Taxes, Political Gridlock, and India's 2012 Budget
The Future of Economic Policy in India

Interview with Pravakar Sahoo
May 21, 2012

In January, NBR spoke with India-based economist Pravakar Sahoo (Institute of Economic Growth) about the outlook of India’s economy and the potential for FDI to stimulate growth. Since then, India has brought forth its 2012–13 budget, held influential elections in five states, had its economic outlook downgraded from “stable” to “negative” by Standard & Poor’s, introduced a tax amendment that has greatly worried many foreign investors, and more. In an interview with NBR, Dr. Sahoo examines the importance of these developments and outlines what the Indian government should do to achieve its target 8%–9% growth rate.

The Indian government released its budget for 2012–13 in March. When we spoke in January, you said that for India to indicate it is serious about market reform, the government should consider inflationary pressure on economic growth and prioritizing major reforms in sectors including retail FDI, banking, pensions, insurance, and civil aviation. To what extent are these issues addressed in this budget? What will be some of the implications of the budget on India’s economic growth for the year to come?

The Indian economy has been on a downtrend for two years, owing to a lack of investor confidence, a slow-down of policy reforms, and uncertainty in the euro zone. The Union Budget 2012–13 was expected to announce major reforms to revive economic growth prospects to 8%–9% GDP per year. However, the announced 2012–13 budget faired much below expectations. Instead, it is a working budget that contains much rhetoric about policy reforms but lacks concrete steps. Although Finance Minister Pranab Mukherjee reiterated the country’s core problems, such as an uncontrolled fiscal deficit, tapering economic growth, and ballooning subsidies, he did not provide feasible and effective steps to address such critical issues. Allowing 51% FDI in multi-brand retail is still on hold and there seems to be no positive development in this regard, though the finance minister hopes to clear it through the cabinet by building a consensus with his governing United Progressive Alliance (UPA) partners and the opposition.

Some of the major pending reforms necessary to boost investor confidence and attract foreign investment include a banking amendment that proposes to lift a 10% cap on voting rights, an insurance bill which would hike up the FDI limit to 49% from 26% in the insurance sector, and reforms in the pension sector. However, the annual budget for 2012–13 does not address these issues.

Given the log-jam between the UPA and the opposition on issues ranging from corruption to “black” money, it is unlikely that the present government, led by the Indian National Congress, could build consensus and move forward with big ticket reforms in the financial sector. However, the government is pursuing an agenda to allow up to 49% foreign investment in the civil aviation sector. The latest word is that the cabinet committee has circulated a note on this and a decision will soon be made. FDI in the civil aviation sector would be very useful as many airlines are short of capital and are on the verge of collapse. If foreign airlines took up to a 49% equity stake, this would not only bring much needed capital, which is necessary for India’s growth story, it would also improve India’s image as an investment destination in this sector and overall.

India’s civil aviation industry is undergoing a crisis with two of its largest airlines, Kingfisher and Air India, incurring huge losses and struggling to survive. To address the sector’s immediate financing concerns, the 2012–13 budget proposed to permit external commercial borrowings (ECB) for the airline industry’s working capital requirement for a period of one year, subject to a ceiling of $1 billion. Further, the budget curtailed customs duty on aircraft parts and proposed to fully exempt both new and retreaded aircraft tires from basic customs duty and excise duty. The government has also allowed Indian carriers to directly import aviation turbine fuel to reduce these costs.

Two other major pending reforms are the national tax on goods and services and the direct tax code, both which were not addressed adequately in the budget. The fiscal deficit target of 5.1% of GDP looks ambitious as growth is on a downturn, and thus revenue mobilization will likely be much more difficult.

Infrastructure bottlenecks are another problem that is making the Indian economy less competitive. The 2012–13 budget proposes issuing tax-free bonds worth Rs 60,000 crore ($11.1 billion) and bringing more sectors under the umbrella of viability gap funding (VGF) to bridge the huge demand-supply gap in the infrastructure sector. However, some of the major issues in this sector have not been addressed, such as the tariff policy, fiscal incentives, private-sector participation, public-private partnerships, and land acquisition.

Overall, the 2012–13 budget failed to bring about the required reforms to boost the image of Indian economy and investor confidence The outlook of the Indian economy does not look positive and it will likely be difficult to achieve a growth target of 8%–9% GDP per year, which makes this year’s budget disappointing. Moreover, this was the current government’s last opportunity to carry forward reforms, considering that with general elections looming in 2014, the government would likely prefer to provide subsidies or sops rather than deal with reforms that are politically sensitive and debatable. Thus, the outlook for Indian economy is not good given the rising current account deficit, fiscal deficit, investment outflows, and weaker rupee.

When we last spoke, the Indian government had decided to postpone FDI in multi-brand retail. You then said that there would not be much movement on the issue until after the legislative assembly elections. Now that the results have been counted and the budget released, what has changed on the multi-brand retail issue, if anything?

There has been no change in the government’s policy and FDI in multi-brand retail is still on hold. Though the government, under Prime Minister Manmohan Singh, is trying to build consensus among different political parties and stakeholders, it looks difficult at this point in time. The Indian National Congress, the principal party in the UPA, did not fare well in the state elections in Goa, Manipur, Punjab, and Uttar Pradesh, Uttaranchal, making its position weaker than before. Both opposition parties and some of the UPA alliance partners are not in favor of allowing 51% FDI in multi-brand retailing, so the prospects for reaching a positive decision soon appear bleak. The government has, however, allowed 100% FDI in single brand retailing, a welcome development.

In late April, the ratings agency Standard & Poor’s downgraded India’s economic outlook from “stable” to “negative.” This potentially jeopardizes the country’s long-term rating of BBB-, which is the lowest investment-grade rating. How should outside observers interpret S&P’s decision? Is Finance Minister Pranab Mukherjee correct that there is “no need for panic?”

Yes, Standard & Poor’s downgraded India’s outlook from stable to negative. The lowering of India’s economic outlook from BBB+ to BBB-, just above junk status, has come as a blow to the perception and image of the Indian economy. The change in rating was based on the falling growth prospects of the Indian economy, a high fiscal deficit, a lack of fiscal reforms, and an increasing current-account deficit.

While Finance Minister Mukherjee is right to say that there is no need to panic, as the Indian economy is still growing roughly 7% per year, the downgrade of India’s economic outlook will further devalue the rupee, dent the confidence of both domestic and foreign investors, and raise the borrowing costs for Indian companies in the international market. This will drive those investors to refinance debt and will have a negative impact on the confidence of foreign investors. This downgrade is certainly a blow to India’s reputation as a high-growth emerging economy and investment destination. The failures of this year’s budget to bring down the total government expenditure on subsidies, revive the ever-shrinking debt profile, and improve the investment scenario are responsible for this economic outlook.

Foreign investors have been very worried about a set of tax proposals announced as part of this year’s budget. What have been the primary reasons for their concerns and are they likely to be remedied? How might this taxation issue impact India’s ability to attract FDI overall?

The budget for fiscal year 2012–13 proposes an amendment to the Indian Tax Act of 1961, allowing for retrospectively taxing overseas transactions involving the transfer of Indian assets in cases up to six years old. This income tax amendment makes subject to Indian taxes any income generated by businesses created in India, even if the transaction is from the transfer of shares of a company incorporated outside India by a foreign seller to a buyer who also resides outside the country.

There is concern the tax amendment may violate the legal protections granted to foreign companies under bilateral investment treaty provisions. While Finance Minister Mukherjee assures that the amendment will not dilute tax benefits under tax treaties and foreign investors will not be doubly taxed, this uncertainly has created vulnerabilities among foreign investors and reflects a lack of policy stability in India.

At the heart of this issue is that it could result in Vodafone paying India over $3.7 billion in taxes and late fees on a transaction to buy a controlling stake in the Indian mobile phone unit of Hong Kong–based Hutchison Telecommunications International Ltd (HTIL).

In the case of the Vodafone-Hutchinson deal, when Vodafone acquired the Indian unit Hutch Essar, both were foreign companies. However, Hutch Essar operates in India and derived value from its shares. The Indian government holds the view that the indirect transfer of shares of a foreign company that owns assets in India to another foreign company is equivalent to selling and changing ownership of Indian assets. Therefore, the Vodafone-Hutch deal would be subject to Indian tax law, as are similar transactions.

This is contrary to a January 20 ruling by India’s Supreme Court, prior to the introduction of the retrospective tax amendment, which stated the government could not levy capital gains tax on an overseas sales or transfer of shares where the underlying assets are in India.

A lack of clarity in the tax environment and in these retrospective classifications has decreased investor sentiment.

The introduction of the General Anti-Avoidance Rules (GAAR) as part of the new budget, which aimed to target tax evaders, has further aggravated the situation. The purpose of GAAR is to examine whether any transactions are undertaken through “impermissible avoidance arrangements” to reduce, avoid, and defer tax. As many of those investing in India had opened offices in countries such as Mauritius and routed investments through there to avoid taxes under India’s Double Taxation Avoidance Agreement (DTAA), this proposal requires that taxpayers establish that their transaction structures are not practicing tax-aversion tactics.

GAAR may override any other existing international investment treaty or law and implies that any transaction under the DTAA treaty could be overruled if it is triggered. However, in a possible response to the outcry by the foreign business community, GAAR has been deferred for one year. The difference between GAAR and DTAA is not healthy, as it creates uncertainty among foreign investors who need to demonstrate the structure and authenticity of their businesses.

Are there any other recent developments in India’s economy that you feel are important for U.S. policymakers, corporate leaders, and opinion-shapers to understand?

It is true that the Indian economy has slowed down, but it is still one of the fastest-growing major economies in the world, with a 7% annual growth rate. Although policy reforms have been slow and far from expectation, India is one of the top investment destinations in the world. Given that there is a growing middle class and thereby growing market opportunities, U.S. investors should explore Indian markets with greater interest and intensity. The recent visit by U.S. Secretary of State Hillary Clinton focused on economic and strategic issues such as security and civil nuclear cooperation as well as U.S. investment in India in the fields of IT, tourism, education, health, and manufacturing. This is an encouraging sign for U.S.-India investment relations. Talks between Secretary Clinton and Indian policymakers to allow FDI in multi-brand retail are also a welcome step.

There were some positive signs in the fiscal budget for 2012–13, as well. The budget has made good progress in capital market reforms, such as allowing Qualified Foreign Investors (QFI) access to the Indian corporate bond market, simplifying the process of issuing initial public offerings (IPO); allowing electronic voting facilities to provide opportunities for wider shareholder participation; and two-way fungibility in Indian Depository Receipts (IDR) permitted subject to a ceiling. These reforms are expected to further strengthen and deepen Indian capital markets, which would expand investment opportunities for both nonresident Indians and foreign institutional investors.

Pravakar Sahoo is an Associate Professor at the Institute of Economic Growth (IEG). The views expressed here are his own and do not reflect the position of the Institute of Economic Growth.

This interview was conducted by Sonia Luthra, Assistant Director for Outreach.