Memo to FM Jaitley: Subsidy, energy reform more important than GST and fiscal deficit

The finance minister, now on a tour of south-east Asia to drum up investments for India, made his government’s focus clear. Among those he mentioned as his priorities, ease of business clearly is a no-brainer. That has to continue. He also talked about resolving tax disputes with the likes of Vodafone, Cairn and Shell – all victims of the retrospective tax legislation of the UPA – and speeding up the implementation of the goods and services tax (GST) and reining in the fiscal deficit, which has been pencilled in for 3.9 percent of GDP this year. [caption id=“attachment_2437512” align=“alignleft” width=“380”]  Arun Jaitley. PTI[/caption] Actually, Arun Jaitley needs to recalibrate his priorities. The easiest way to end tax disputes is to remove that abomination inserted into tax law by Pranab Mukherjee after the government lost the Vodafone case in the Supreme Court. While it is not my case that Vodafone did not try to evade Indian taxes by using some loopholes in the law, such disputes have to find closure at some point – and a Supreme Court verdict was the right place to end them. The retrospective tax law clarification inserted by Mukherjee to make things absolutely clear should have been avoided. It only made India a riskier place to invest in. Jaitley should rewrite the law to make it only prospective in nature. He does not need the support of the Congress or anyone else to change this law, and he must do it pronto. In fact, his predecessor P Chidambaram has criticised him for not doing so, and so Jaitley has good reason to go ahead and do it in the winter session of parliament and not wait for the next budget in February 2016. On his other two priorities, too, Jaitley needs to do a rethink. His repeated batting for a flawed GST is worrisome. GST is a good tax only to the extent it is an all-encompassing impost that replaces all existing state and central taxes. But the GST now planned has too many flaws , and too many exclusions (alcohol, petroleum, and some other municipal levies). Moreover, the states are still uncomfortable with giving up their revenue flexibility by signing on to GST. Jaitley seems to have accepted the general urgings of business claiming GST as reform. But this would not be true. A GST full of exclusions and which also includes an additional tax of 1 percent on inter-state sales will make the actual revenue-neutral rate very high, probably above 20 percent, and hit the most productive sector (services) the hardest. A bad GST is not reform. Jaitley’s other priority - his focus on the fiscal deficit - is not wrong, but what matters here is the emphasis. In a world where deflation is the real worry and Indian exports are dropping sharply, the emphasis has to be on domestic growth, and this calls for a more nuanced approach to the fiscal deficit. This should be his mantra: a focus on the quality of the fiscal deficit, and not on the headline number of 3.9 percent of GDP that he promised in the budget. Improving the quality of the fiscal deficit means he must try and cut out unproductive expenditure, and boost productive expenditure. Cutting the overall size of the fiscal deficit is less important than cutting out the wrong expenses and boosting the right ones. But is this what is happening? While two ministries – roads and railways – seem willing to expedite projects, the public sector units as a whole do not seem to be playing ball. According to a Business Standard report today (21 September), public sector units actually cut capital expenditures by 24 percent in 2014-15 – with the energy sector leading the downtrend. Investments in crude oil and gas were down a whopping 50.4 percent, refineries by 9 percent, and power by 7.4 percent. The energy sector is clearly unable to invest, thanks to the sharp fall in oil prices and the losses faced by state discoms. While the oil refineries are in better financial shape today after diesel price deregulation, it is unlikely that there will be an increase in energy sector investments in the foreseeable future unless Jaitley is able to address their issues more innovatively. The fiscal deficit should not be considered a constraint in fixing these structural issues. So what should his priorities really be? #1: Jaitley must focus first on subsidy reforms by extending them beyond LPG. On LPG, where the subsidy is directly paid to customer accounts, the savings generated by eliminating fake claimants and appeals to the rich to give up subsidies are said to add up to Rs 15,000 crore this year. Consider how much more can be saved if kerosene is brought under the direct benefits transfer (DBT) scheme next and then extended to food and fertiliser. Oil subsidy reform alone has the potential to deliver savings of up to Rs 50,000-and-odd crore for the exchequer. After that, there is fertiliser and food to yield more. #2: Boosting capital investment needs a government push – and this means the fiscal deficit target ought not to be cast in stone this year and the next. The two big constraints to boosting investment are poor bank capitalisation, and excess demands on public sector undertakings’ (PSUs) cash resources. Over the last three years, the centre has sought higher dividend payments from cash-generating behemoths like Coal India, ONGC and Oil India to meet its fiscal deficit targets. This is one reason why these companies are low on the investment side. ONGC, GAIL and Oil India also have to bear the subsidy burden on LPG and kerosene, which means the fiscal deficit has really been shifted to the public sector from the exchequer. This is not fair. If ONGC, Coal India and other public sector units have to help restart the investment cycle, they have to be able to find more resources internally for it, and this won’t happen if subsidies become their problem instead of the government’s. Logically, it should be acceptable to let the fiscal deficit rise on this count if the cash-generating PSUs are able to restart investing in new projects. Investment is the only route to growth and keeping the fiscal deficit low on the exchequer side while transferring subsidy burdens to PSUs is just an accounting trick. #3: Bank recapitalisation is now on a higher priority than before, with project Indradhanush promising Rs 70,000 crore of capital for banks over a four-year period, with Rs 25,000 crore this year. However, it makes more sense to fast forward this recap process to two years, and then let stronger banks raise more funds from the capital market after that. Right now, government funds are the best bet for them. It should be acceptable to let the fiscal deficit rise marginally in the short run in order to recapitalise banks faster as long as it is clear that the deficit will start falling over the medium term. #4: We simply need a more sensible scheme to reduce state power distribution companies’ (discoms) losses and amortise their massive debts or overdues to power generating companies. Accumulated losses of discoms crossed Rs 3,00,000 crore in 2013, and continue to rise even now. The Vajpayee government managed to improve power sector viability by offering a one-time scheme, and the time is appropriate for another such scheme now, even if it means some expansion in the centre’s fiscal deficit. The states, of course, must be asked to do the bulk of the reforming if they want central help. After the 14th finance commission report, they have more resources than before to do so. The broader point is this: it does not matter if the fiscal deficit slips to 4 or 4.1 percent this year, as long as the quality of the deficit is much better and as long as the money is going to boost investment rather than bankroll subsidies. This is the shift that Jaitley needs to engineer. Trying to chase a half-baked GST or a fiscal deficit target that does not make sense in the current global economic environment will be counter-productive. Energy sector and subsidy reforms are as big as GST in scope, and here it is the centre that can do most of the pushing.