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FinanceNew Exchange Rate Regime: Partial and Full Convertibility, Capital Account ConvertibilityNote: Capital account covers variety of financial flows, such as FDI, portfolio flows (investment in equities and debt), and bank borrowing, all of which have in common the acquisition of assets in one country by residents of another country. There are no set benchmarks for measuring a country’s capital account openness- the IMF maintains a list of each country’s capital account restrictions, but there’s no way to quantify their ‘intensity’.Current indicators: External debt to GDP: 23% (was 29% in 1991)Forex reserves to External debt: 70% (7% in 1991)Until the early 1990s, India had very strict capital controls, which allowed for monetary policy independence along with fixed exchange rates. Since 1993, however, India substantially eased capital and current account restrictions, and hence had to deal with increased money flows, meaning that exchange rate no couldn’t be strictly fixed. India’s exchange rate regime has been, on paper, one of market-determined exchange rates. In reality, the RBI intervenes regularly in currency markets, and the rupee is de-facto loosely pegged to the USD. The extent of the pegging does vary according to market conditions, but is usually not allowed to fluctuate wildly.This leads to some loss of monetary policy autonomy.India currently has full convertibility of the rupee in current account, but for capital account, there are ceilings, including on government debt, external commercial borrowings, and equity.Full Capital Account Convertibility (FCAC) allows local currency to be exchanged for foreign currency without any restrictions on the amount. Although CAC freely enables investment in the country, it also enables quick liquidation and removal of capital assets from the country, both domestic and foreign. It also exposes domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.Reasons countries want to shield themselves from unbridled global capital flows:Stabilization of exchange rateIf domestic banking systems are not well developed, exodus of domestic savings to foreign countries Short-term capital flows can be reversed quickly, thereby adversely affecting the macroeconomic situation of the country Controls allow for directing the flows towards more stable forms of capital inflows, such as FDIs, rather than ‘hot money’ flowsArguments in favor of capital account liberalization:Achieves optimum allocation of global financial resources; helps attract foreign investment, and also allows domestic companies to better tap foreign marketsAllows EMEs to raise the level of capital formation above their domestic savings rateAccess to capital markets can allow countries to ‘insure’ themselves to some extent against fluctuations in their national incomes such that national consumption levels are relatively less volatileIt can signal a country’s commitment to good economic policies. A perceived deterioration in a country’s policy environment could result in capital flight. This provides a strong incentive for policymakers to maintain sound policiesInflows stemming from liberalization should also facilitate the transfer of foreign technological and managerial know-how and encourage competition and financial development, thereby promoting growthWhat does the evidence say?The linkage between capital account liberalization and sustained high growth is weak at bestEMEs have not been able to use international financial markets effectively to reduce consumption volatility; there is a significant pro-cyclical element to international fund flows for such countries. Thus, investors pull back in hard times, thereby deepening domestic crisesOpen capital accounts can lend a hand to imprudent fiscal policies, by providing access to excessive external borrowing Open capital accounts along with efforts at maintaining a stable exchange rate regime has led to macroeconomic crises; countries that have only gradually eased capital account restrictions seem to have had overall better outcomes One of the key pillars of the success and stability of East Asian economies was that debt was largely domestically financed. This allowed these countries to sustain high levels of leverage as well as high levels of investments for a long time. Capital controls ensured that external dependence was minimal. But once the capital account was opened up, these economies became extremely vulnerable to global funding shocks?Nevertheless, sound domestic policies and institutions, a regulatory framework that promotes a strong and efficient financial sector, and effective capital flow monitoring systems greatly improve the chances of ensuring stable and beneficial flows. Before 2008, the IMF was overwhelmingly of the view that full capital account openness and free exchange rates were necessarily a good thing. Since 2008, however, there is an emerging consensus the world over that countries should have sufficient tools at their disposal to tide over difficult times, and hence capital account liberalization should be slow and well thought out. Some questions for India to consider:Should all inflows be made completely free? Currently, there are restrictions, mainly in the form of limits on amounts invested by foreign investors in government and corporate bonds. This is to promote financial stability. The policy objective here should be to create domestic market conditions that will minimize the potentially destabilizing effects of foreign investment. We need to figure out if such conditions exist and can realistically be created; if not, some prudence, in the form of caps, may continue to be justifiedCritically, capital controls cannot go unless there is macroeconomic stability, a healthy fiscal situation, and the inflation is low. India is a long way away from this.In general, given the international experience, India should keep prioritizing FDI as the preferred route for foreign investments into India, and go slow on completely opening up the capital account. Aside: Participatory notes-Participatory Notes?commonly known as?P-Notes?or?PNs?are instruments issued by registered foreign?institutional investors?(FII) to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator (SEBI)They account for about 50% of all FII inflowsNeed:Anonymity: Any entity investing in participatory notes is not required to register with SEBI (Securities and Exchange Board of India), whereas all?FIIs?have to compulsorily get registered. It enables large hedge funds to carry out their operations without disclosing their identityEase of Trading: Trading through participatory notes is easy because participatory notes are like contract notes transferable by endorsement and deliveryTax Saving: Some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countriesMoney Laundering: PNs are becoming a favorite with a host of Indian money launderers who use them to first take funds out of country through?hawala?and then get it back using PNsSEBI is not happy with P-Notes because it is not possible to know who owns the underlying securities and hedge funds acting through PNs might therefore cause volatility in the Indian markets-----------------India’s capital account:Two benefits of financial openness- access to foreign capital, and development of local finance systems: The principal benefit of financial openness for developing economies may not be access to foreign capital that helps increase domestic investment by relaxing the constraint imposed by a low level of domestic saving. Rather, the main benefits may be indirect ones associated with openness to foreign capital, including the catalytic effects of foreign finance on domestic financial market development, enhanced discipline on macroeconomic policies, and improvements in corporate governance as well as other aspects of institutional qualityIn recent years, the Reserve Bank of India (RBI) has taken what it calls a calibrated approach to capital account liberalization, with certain types of flows and particular classes of economic agents being prioritized in the process of liberalizationAt this juncture, a more reasonable policy approach is to accept rising financial openness as a reality and manage, rather than resist (or even try to reverse), the process of fully liberalizing capital account transactionsIt is not advisable to remove all the restrictions on the capital account in one broad sweep; rather, a steady progress towards a more open capital account is neededCurrent evidence as to the impact of having an open capital account on growth in inconclusive- however, it can be established that usually the constraint to development in developing economies is not the lack of domestic savings, but a lack of investments, which is caused by underdeveloped financial systems. In this regard, an open capital account can indirectly promote growth by aiding the development of local financial systems, and hence promoting both domestic and international savingsIndia has generally moved towards an open capital account when it comes to two kinds of flows- FDI inflows and equity portfolio inflows. It has maintained restrictions on debt flows, which is prudent, given that the international experience shows that stocks of external debt liabilities are more risky (I think this means that Indians can not buy debt abroad easily, and foreigners cannot buy Indian debt easily, but I’m not certain). Evidence also shows that for developing countries, the benefits to TFP flow from FDI investments, and not from debt flows (debt flow is when an Indian company issues debt shares abroad) The RBI has in fact eased a number of controls, both on inflows and outflows. For instance, although capital outflows by individuals are in principle still restricted, each individual is allowed to take up to $200,000 of capital out of India each year, a generous ceiling by any standards. The restrictions on outflows by Indian corporates are even weaker. As for inflows, FDI inflows into certain sectors such as retail and banking are restricted, and foreign investors are not allowed to participate in the government debt market. These restrictions are gradually being lifted. Equity market investments are permitted by registered foreign institutional investors (although there are limits on their ownership shares in certain types of Indian firms), and those who do not wish to register can invest only indirectly through an instrument called participatory notes, which are tightly regulated by the government.Despite this, on relative scales, India’s financial openness ranks towards the bottom of the pile when compared with other emerging market economies (and very much so when compared against the rest of the BRIC countries)India’s inflows are majorly composed of FDI and portfolio inflows; outflows are overwhelmingly FDI, and minuscule portfolio flowsForeign investors are not allowed to invest in government debt markets => government doesn’t borrow from abroad, but only from domestic investorsIndia is still a minor player in the global financial markets- in terms of FDI inflows, we account for about 5% of total global glows; and about a similar % of FDI outflowsRecent global experience suggests that it might be unwise to hastily move towards full capital account openness- India’s current strategy of promoting FDI and portfolio flows and limiting debt flows seems to be working well. However, with the rising integration via FDI and portfolios, it is near- impossible to limit only certain kinds of flows (debt), and might well prove impossible. It might thus be better to move towards more openness, to leverage the indirect benefits (development of local financial systems)In Budget 2015, it has been mentioned that the regulation making power for equity-related capital flows will now move to the government, while the RBI will continue to regulate other kinds of flow (primarily, FDI and debt flows)Fiscal Responsibility Act, Fiscal ConsolidationThis was introduced in 2003, but scrapped in 2009 following the government’s rising fiscal deficit following the 2007 financial crisis. The FRBM act was enacted to:Introduce transparent fiscal management systems in IndiaIntroduce a more equitable and manageable distribution of the country’s debts over the yearsAim for fiscal stability for India in the long runThe main aim was to eliminate revenue deficit of the country, and bring down the fiscal deficit to a manageable 3% of GDP by March 2008.The average fiscal deficit numbers for a few periods are as follows:Period1985-941995-042004-072007-082008-092009-102010-112011-122012-132013-14Gross Fiscal Deficit7%5.53.92.766.95.15.84.94.5Thus, it can be seen that before the FRBM act came into place, India’s fiscal deficit was generally quite high, and the enactment of the act did lead to fiscal consolidation till the financial crisis hit, and the compulsions of providing a stimulus package for the economy again led to a widening fiscal deficit. The goal for the current fiscal year is 4.1%, with the aim of reducing the FD to 3% by 2016-17. However, while looking at the above table gives the impression that the FRBM act was an unmitigated success, we need to see where the reduction in the expenditure was coming from. In essence, there are three ways to reduce the fiscal deficit: increasing the revenue receipts (generally possible via higher tax receipts), decreasing revenue expenditure, or reducing capital expenditure. While the first two are preferred ways to reduce FD, cutting down on CapEx is easier, but hurts the economy (thereby hurting tax receipts as well), and also social services expenditure in education and health.Data shows that the structure of expenditure has worsened in the post-FRBM phase, with a rising share of revenue expenditure and a falling share of capital expenditure: share of revenue expenditure in the budget rose from 77% in 2004 to 89% in 2008, and to xx in 2014-15. Although the fiscal deficit has been reduced to 4.1% in the current budget, a large part of the decline comes from declining capital expenditure. A budget deficit emerging from capital expenditure is much less harmful than when it emerges from current expenditure, because the latter means the government has to borrow capital to fund consumption. This reduces the total savings in the economy and puts pressure on prices. Borrowing for capex does mean that the government’s over-presence in the debt market will push up interest rates, but there is no reduction in savings and no pressure on prices. Thus, the government should try and bring the revenue deficit to zero, but not by cutting capital expenditure. So far, the gains that have been seen in recent fiscal consolidation have come from robust economic growth and macroeconomic stability, coupled with a tax structure based on reasonable rates, fewer exemptions, and better compliance. The focus has not been on expenditure restructuring, and that is what we need. Going forward, we should focus on the following things:Restructuring of expenditure compositionInstitutional reform: Either instituting an autonomous Fiscal Council that recommends ways towards fiscal consolidation to the government, or increasing the current powers of the CAG so that it can play out this role. Deficit reduction targets need not be insisted upon rigidly year to year, but should be operated with some flexibility depending upon he exigencies. A golden rule as in UK, i.e., borrowing only for capital spending, should be institutedReporting requirements should be made more stringent Escape clause must be tightened and penalties imposed for non-complianceTwelfth Finance Commission, Fiscal FederalismIn any federal fiscal system, resources are generally assigned more to the center, while the states have larger responsibilities. This creates a vertical imbalance. Also, different states within the union have different revenue-raising capabilities, which results in horizontal imbalances. The constitution of India mandates the creation of a Finance Commission every 5 years to suggest ways to correct these two kinds of imbalances (vertical and horizontal).The role of the FC is generally two-fold:Recommend how to split the total tax revenue accruing jointly to the union and the statesRecommend grants-in-aid depending on specific needs of different states (these can be in the nature of budget support for state plans, block grants under different sectoral heads (education, health, infrastructure, power, roads, heritage conservation etc.), centrally planned schemes, part of centrally sponsored schemes etc.)While this has been the general trend of the job of FCs, the TFC’s ToRs included another query- how to ensure fiscal consolidation in the country (i.e., how to restructure public finances with a view to restore budgetary balances, maintain macroeconomic stability, and bring about debt reduction along with equitable growth)? This was something new, only included in the TFC’s ‘questions to answer’ list. During the time of TFC’s drafting recommendations, the overview was that almost all state governments had large debt burdens that translated into such huge interest payments by state governments that they effectively couldn’t undertake productive social expenditure, leading to deterioration in quality of public services. In this light, the major new recommendations of the TFC regarding fiscal consolidation were as follows:Macroeconomic stability:Increase the combined center-state tax-GDP ratio to 17.6% by 2009-10 (in 2015, the combined ratio stands at about 15%; and at about 10% only for the center)Fiscal deficit to GDP ratio for the center and the states must be fixed at 3% of GDP eachEach state should aim to enact a fiscal responsibility legislation, that should provide for:Eliminating the revenue deficitReducing fiscal deficit to 3% of GSDPDebt relief: Central loans to states outstanding in 2005 were to be consolidated and given a fresh term of 20 years for repayment, at the rate of 7% p.a.Repayments due from 2005-2010 would be waived off, conditional on when and if the state government enacts the recommended fiscal responsibility legislationBorrowing by states:Before the TFC, any state that wanted to borrow from commercial banks had to take written approval from the RBI, and this wasn’t always granted; debt provided by multilateral institutes had to be routed via the central government, which would impose a higher rate as compared to the lending institutionTFC recommended relaxing the prohibition on states hiring directly from the market- the center would stop lending to the states, who would now have to go to market to borrow. It was hoped that this would inculcate fiscal discipline amongst the states, as they will have to borrow at market-determined interest rates, and there will be no expectation of bail-outs by the centerExternal assistance (from WB, IMF, ADB etc.) was now to be transferred to the states with no extra T&Cs imposed by the union government over and above those imposed by the agencies themselves; i.e., the union government would simply act as an intermediary and not as a usurious lenderLoan Council:The TFC also stressed the need to have an independent body like the Loan Council to decide the borrowing limits for the states and oversee their implementationCriticisms:The debt relief plan was confined only to a small % of the total debt of the statesThere was no real logic behind imposing the exact same numerical limit of 3% of GSDP as fiscal deficit for all states; there also needs to be a distinction between borrowing for current consumption versus borrowing for productive capital investmentsLocal Bodies: TFC did not make the local bodies a part of the restructuring plan. The most important rationale of local governance is the provision of certain basic services of standard quality at the local level; while horizontal equity among various local bodies is primarily the responsibility of SFCs, UFC also has some responsibility. Some stats on finances of local bodies in India:Total expenditure of local bodies as a % of the combined expenditure of union, state, and local bodies works out to be only around 5% (as of 2002); in advanced countries, this is usually around 20-35%Tax revenue of local bodies (as a % of local+state tax revenue) is only about 2%Clearly, despite tall claims about decentralization, fiscal decentralization in particular hasn’t made much progress in IndiaWith regards to local body finances, some urgent steps required are as follows:Building a reliable database of public finance datasets at the local body levelNeed for real functional mapping and role clarity between state government and various tiers of sub-state level governments Decentralization used to be one of the parameters used till the 11th Finance Commission for deciding devolution of funds; FFC did away with this criteria. There might be some merit in bringing it backFourteenth Finance CommissionSummary of recommendations:42% of total tax revenue to be devolved to the states:Factors for determining which state gets what share of tax revenue: Population (1971- 17.5% weight; 2011- 10% weight), Area (15%), Forest Cover (7.5%), Fiscal Capacity, measured as income distance, which is the difference between the state’s per-capita income and the per-capita income of the highest earning state in India (50%)Central transfers can be divided into the following two categories:Transfers from the divisible pool of taxes (excludes cess etc.)Grants-in-aid, covering grants recommended by the FC, and not the ones that support state plans/ CCSsAside from these, center also does non-FC recommended transfers that include grants for state-plan support, and grants to fund CCSs. While the FC transfers are statutory and do not impinge on states’ fiscal autonomy, the other two kinds of grants described above are tied to conditions/ sectors, and do impinge on fiscal federalism. What this means for the overall transfers from the center to the states is as follows:Transfers as % of GDP (budget 2015/16)2013/142015/16Total transfers from center to states 5.555.95Tax devolution 2.813.71Grants (cumulating all three kinds of grants- non-plan, state plan support, and CCS support)2.752.24Thus, as we can see, the increase in tax devolution is not revenue neutral for the center- that is, the decline in grants-in-aid does not cover the increase in tax devolution. This is inevitable, given that some CCSs like MGNREGA are constitutionally mandated and need to be funded no matter what.Local governments:FFC has been quite generous in recommending a larger grant to local governments (includes Panchayati Raj Institutions (PRIs) and Urban Local Governments (ULGs)The allocation to local governments is over twice the amount recommended by the 13th FC, and for ULGs it is nearly three times relative to the 13th FC recommendations While there was a clamour by various state and local governments to allocate at least 5% of the divisible pool to local governments, the 14th FC has recommended a grant-in aid for local governments that is equal to an estimated 3% of the divisible poolDistribution of LG grants to the states based on 2 factors: 2011 population (90% weight) and area (10%)Grant to each state should be divided into two; one part strictly for gram panchayats, and the other only for municipalities; the division should be on the basis of urban and rural population figures for the statesGrants for both these kinds of local bodies will be of two kinds: basic grants (80-90%), and performance grants (10-20%) (rural-urban)The performance grant to urban local governments is to be given if they fulfil three conditions – have their accounts audited, improve own revenues, and publish service-level benchmarksThe share of performance grants has been reduced from 35% in ThFCSFC to decide the sharing of grants within the stateState and local governments should explore the possibility of issuing municipal bonds as a source of financeBetter accounting and reporting procedures at the LG levelREFORMING THE INDIAN FINANCIAL SYSTEM (Ajay Shah)In the last decade, India’s domestic savings rate has increased from about 24% to about 35%. In addition, gross capital formation by the private sector increased from about 7% to 14% (2008-09 numbers). This implies that the Indian financial system has grown to a significant size by any international standards, handling about $400 billion of household savings and about $150 billion of private corporate investments. However, the financial system still remains underdeveloped, and even marginal improvements would significantly help towards promoting growth. Some salient features of the Indian financial system are as follows:Financial Repression: Of the total debt issued by Government of India, only about 15% is held by private individuals. The pubic sector financial institutions, such as banks, insurance firms, and pension funds, are forced to hold the rest. The government, thus, gets about 25% of banks’ assets, about 50% of insurers’ assets, and all of pension funds’ assetsBanks, insurance companies and pension funds would be safer if their assets were diversified internationally, including purchases of government bonds of countries with lower credit risk than that of the Indian governmentWhen investors voluntarily buy government bonds, the cost of financing will reflect perceptions of fiscal stability. Through this, a subtle system of checks and balances will arise, nudging the government towards fiscal prudenceProtectionism: There are very stringent restrictions on the banking business in IndiaThe beneficiaries of India’s protectionism in finance are the domestic financial firms, who face reduced competition and are thus able to pay elevated wages and generate elevated return on capital. The costs of this regime are imposed upon households and firms, who obtain financial services of inferior quality and elevated priceIndian users of financial services – both households and firms – will benefit from global standards of quality and pricing of financial services. Some Indian firms would find it difficult to cope with competitive pressure, and exit. But many firms would achieve high productivity, and go on to export and build globalized businessesPublic Ownership: Roughly 80% of banking, 95% of insurance and 100% of pensions is held in public sector financial firmsAt the same time, competitive dynamism is found in certain areas. The barriers are the weakest with securities firms that seek to become members of exchanges such as NSE and BSE, and with mutual funds. In these two areas, India is de facto open to private or foreign firms that seek to establish business. Unsurprisingly, these are also areas where creative destruction is visible, with both entry and exit taking place every ernment ownership of banks hampers financial development and reduces economic growthOne element of the difficulties associated with public ownership is poor in- vestment decisions, coupled with claims upon the exchequer for recapitalizationUnder the present legal arrangements in India, deposits with public sector banks are guaranteed without limit by the government. Under difficult conditions, such as the financial stress of late 2008, depositors have an incentive to switch from private banks to public banks. Thus, even a small presence of public sector banks with unlimited deposit insurance exacerbates the risk faced by private banks and induces systemic riskCentral Planning: Government controls minute details of financial products and processesIn this environment, the process of change is slow. If a financial firm gets an idea for an improvement, it does not reap the benefits (of a short-term advantage over rivals) since it has to go to the regulator for permission, and that permission would be given for all firms symmetrically. Bereft of incentive for experimentation and innovation, financial firms in India have tended to become bureaucracies, merely manning unchanging systemsBureaucrats face asymmetric payoffs, where they can be penalized for actions taken, or when scandals or crises take place. However, bureaucrats pay no cost when the Indian economy suffers from a poorly performing financial systemIn an ordinary market economy, competition between private firms (who have the flexibility to experiment with new ideas) and internationalization (which brings new ideas through foreign players) generates a steady pace of change. In Indian finance, all these sources of change have been blockedRegulatory and Legal Arrangements: Given that financial regulation in India is dispersed across multiple agencies, and given the growing complexity of the financial system, better coordination mechanisms are now called for (see FSLRC recommendations)ECONOMIC IMPACT OF THESE FEATURES:Suboptimal use of capitalWeak monetary policy transmissionLack of financial inclusionGreater systemic risk (adverse impact upon stability)Financial Sector Legislative Reform Commission- RecommendationsPresently, the structure of regulatory bodies for financial sector in India is somewhat haphazard- the existing regulatory bodies- RBI, IRDA, SEBI, FMC, PFRDA- were not created as different parts of an organic whole, but instead their responsibilities and jurisdictions have developed over time as a result of piecemeal legislation, usually in response to pressures emanating from particular incidents. There is, thus, a convoluted structure, significant gaps in regulation, as also significant overlaps between the functions of various regulatory bodies. Also, these regulatory bodies work in sector-specific silos, and thus fail to take a system-wide bird’s eye view of the financial space in the country.To remedy this situation, the FSCLR has proposed a new, unified, non-sectoral ‘Indian Finance Code’ that aims to formulate a single, principle-based code for financial regulators in India. That is, the code outlines certain basic principles, in the basis of which regulations will be formed. These regulations can of course change from time to time, based on current needs of the financial structure, but the principles underlying these rules have to be as outlined in the IFC. These principles are:Consumer Protection: Make financial firms do more towards consumer protection (Budget 2015 announced creation of the Financial Redress Agency, which will be one-stop shop for all kinds of consumer queries/ complaints. So far, given the multiplicity of regulatory agencies, consumers have often been treated as ‘footballs’, with no clarity on responsibility of tending to their complaints. FRA is meant to correct this situation)Micro-prudential regulation: Reduce failure probability of individual financial firms, to ensure that they can follow up on the promises they made to their consumersResolution: Upon failure of firms, ensure quick resolution and winding down of firms, while protecting interests of small consumers (Budget 2015 announced creation of the Resolution Corporation)Managing systematic risk: Looking at the financial sector as a whole to avoid undue risks (Budget 2015 announced creation of the Financial Data Management Centre)Monetary Policy: Create a Monetary Policy Committee at the RBI, move towards an explicit inflation-targeting regimePublic Debt Management: Harmonize the government’s internal and external obligations, which are currently scattered across the RBI and the Ministry of Finance; divest RBI of its public debt management function, and create an independent body for this purpose (Budget 2015 announced creation of the Public Debt Management Agency, but this was subsequently rolled back later)Capital Controls: Commission gave no view regarding thisContracts, trading, and market abuse(Budget 2015 announced the creation of Financial Sector Appellate Tribunal)Development, financial inclusion, and redistributionThe Ministry of Finance has issued a handbook detailing how these reforms are to be implemented, and the handbook gives instructions to the 5 current regulatory bodies. It is expected that the introduction of these reforms in the Indian financial regulatory framework will lead to simpler and more coherent regulations. From the newsTaxation in India:Union subjects (ICE-ICE-CT: Income, Customs, Excise – Inheritance, Capital gains, Estates- Corporation, Transportation by air, rail, or sea)State subjects (LSV-LSV-EMP: Land, Stamp, Vehicles- Luxury (entertainment, gambling, betting, amusement etc.), Sales, VAT (service tax) – Electricity, Minerals, Professions)Minimum Alternative Tax:MAT is a way to make companies pay at least a minimum amount of tax (18.5%)It is applicable to all companies (including foreign companies with income sources in India) except those engaged in infrastructure and power sectorsReasons for MAT: The Indian Income-Tax Act allows a large number of exemptions from total income. Besides exemptions, there are several deductions permitted from the gross total income. As a result, a lot of companies used to show considerable book profits, and distribute large dividends, but were able to use these exemptions to pay close to zero tax. These came to be known as ‘zero-tax’ companies. MAT was introduced to counter thisTax incentives practically bring down the corporate tax rate, and the average effective rate is around 23%, while many large corporates that are investing heavily find the actual rate falls to much lower levels. This is the reason why the government levies MAT on the book profits of companies at 18.5%, as the threshold below which the rate can’t fallThere are rumors that the present government might scrap MAT. They claim that the government is looking at gradually weeding out tax exemptions and concurrently reducing the corporate tax rate, such that MAT will become redundantSummary article hereGeneral Anti Avoidance Rules (GARR):GARR is an anti-tax avoidance rule which prevents tax evaders from routing investments through tax havens like Mauritius, Luxemburg, SwitzerlandInvestors had maintained that the ambiguous language used in the draft of the GAAR could lead to the misuse of the rulePeople adopt various methods so that they can reduce their total tax liability. The methods adopted to reduce their tax liability can be broadly put into four categories: Tax Evasion, Tax avoidance, Tax Mitigation, and Tax Planning. GAAR provides to curb tax avoidanceGAAR empowers the Revenue Authorities to deny the tax benefits of transactions or arrangements which do not have any commercial substance or consideration other than achieving the tax benefit. GAAR is intended to target tax evaders, especially Indian companies and investors trying to route investments through Mauritius or other tax havens in order to avoid taxes. GAAR provides discretionary powers to revenue authorities to tax impermissible avoidance arrangements. The arrangements as a whole or aim part may be disregarded and tax benefit deniedIt was first mooted in 2011, but even in Budget 2015, it has been deferred to 2017, given concerns of some investors who claim that the language used in the rules might be detrimental to profitsGoods and Services Tax:Read: recommended by the task force of the 13th Finance Commission, which pegged the uniform tax rate at 12% (answer why this rate)Deliberation conducted by the Empowered Committee of State Finance Ministers (who set up a Joint Working Group; members: Joint Secretaries of Dept. of Revenue (Union FinMin) and all Finance Secretaries of the States, Convenors: Advisor to the Union Finance Minister, Member-Secretary of the Empowered Committee)Why the single rate?: Eliminates production inefficiencies, ensures no single good is taxed disproportionatelyConsumption taxValue-Added Tax => (Output tax – Input tax) is paid to the government (tax paid only on value added). VAT also follows the destination principle; hence, the GST will not apply for export goods, but will apply to import goods. Also, at every step of the production process, the producers get tax credits, while the end consumer gets no tax credit Dual system: Will be imposed both by the center and the state, and will replace all existing indirect taxes such as excise, sales, service taxesBenefits:Reduction in the number of taxes at the Central and state levelsCut in effective tax rate for many goods by removal of the current cascading effect of taxesReduction of transaction costs for taxpayers through simplified tax compliance Increased tax collections due to wider tax base and better complianceUnification of India into a single market, eliminating the need for border check posts to collect taxes on goods produced in one jurisdiction but sold in anotherGood for consumer statesControversies:Both center and the states want certain high tax-revenue generating goods (like petroleum, alcohol etc.) removed from the ambit of GST => reduces tax baseSome calculations of the revenue-neutral tax rate (post removal of certain goods) are as high as 27% => incentive for evasion => little improvement in complianceIn the currently proposed dual structure, the tax might just be reduced to a renaming of the existing Central Excise Tax and States’ VAT/ sales taxTransaction costs: government will need to make e-infrastructure (‘GST Network’)Attention-diversion cost: other reforms sidelinedCompromises India’s federal structure by not allowing states to set their own rates => restricts the ability of states to determine the level of spending on public goods and services locallyBad for states that produce a lot but don’t consume muchGiven that this is a Constitutional Amendment Bill, this cannot be passed via a Joint SittingRead Pangaria’s articleIn view of the impending changes with the introduction of GST, adequate compensation to ULGs for their loss of income will need to be ensured. The past experience has not been very good in this regard. Many state governments, on abolition of octroi (a tax on entry of goods within the city limits) and in some cases even property tax, had promised compensatory grants to ULGs with an annual increase to maintain the buoyancy. However, compensation to local bodies has remained static and is often not released in timeGST Council: This will be the decision making body that will bring any changes required to the GST Act. It will be composed of the Center and all the states, with the center holding 33% of the voting rights, and the states, 67%. To get any changes approved in the operation of GST, 75% or more votes will need to affirm it. That is, the center has a de-facto veto, whereas a minimum of 12 states will need to come together to block any changes that they don’t agree withBlack Money: Estimates by old CBI chief: $500bn; by Swiss authorities: $2bnSIT instituted by Supreme Court in 2011 under MC Joshi (then chief of CBDT)Recommends harsher sentences for tax offenders, potentially even making tax avoidance above Rs. 50 lakh a criminal offense (currently it is a civil offence)Key observations/ recommendations:Increase punishment under?Prevention of Corruption Act?and the Income Tax ActTaxation is a highly specialised subject. Based on domain knowledge, set up all-India judicial service and a National Tax TribunalLike the USA?Patriot Act,?India should insist on entities operating in India to report all global financial transactions above a threshold limitConsider introducing an?amnesty?scheme with reduced penalties and immunity from prosecution to the people who bring back black money from abroadDevice specific regulations to check large scale possession and transportation of cash, and curb large-scale ‘unreported’ cash dealingsSee the bill under ‘Constitution’ (GS2)Important: For recent SIT’s recommendations, see has come across quite a few cases where GDRs have been used for round-tripping of funds in the name of capital-raising of listed companies from abroadUndisclosed Foreign Income and Assets (Imposition of Tax) Bill, 2015Also known as “black money’ billProvides for separate taxation of any undisclosed foreign income and assets; such income will now not be taxed under the Income Tax ActIt will apply to all residents of IndiaTax rate will be a flat 30%Proposes very stringent punishments; to the tune of 90% of the value of undisclosed assets/ income, to three years of rigorous imprisonmentLiberalized Remittance Scheme:The limit for individual remittances abroad has been raised to $250,000 p.a.There can be some concern about domestic investors investing more in foreign equity markets; however, right now Indian stock market is giving high returns, so might not be a cause for worryMicro Units Development and Refinance Agency (MUDRA) Bank:Set-up announced by budget 2015Initially, this will be a subsidiary of the Small Industries Development Bank (SIDBI), and will later become and independent, full-fledged bankImportant thing to note is that MUDRA bank will not be a lending bank, but will refinance MFIs who are in the business of lending to small entitiesIt will also lay down rules and policy guidelines for micro enterprise financing businesses, registration, accreditation, and starting of MFIsThis will be a bank to finance the setting up of small and micro-units and thereby encourage entrepreneurship among SC/STs and OBCs (lending will be preferentially given to these classes)It will regulate and refinance all MFIs that lend to micro/ small business entities engaged in manufacturing, trading, and services activities Logic is to bridge the funding gap that affects the ‘middle’ – top corporates are funded by the banking system, bottom of the ladder is funded by MFIs, but the middle rung of micro and small enterprises suffers funding problemsAccording to government estimates, only 4% of 5.77% crore small business units have access to institutional finance, leaving many to rely on informal lenderThe bank will regulate MFIs, and lend to ‘last-mile lenders’ that will provide financing to the businesses being targetedAjay Shah calls this a ‘bad idea’: `Mudra bank' is an old style socialist initiative, which is inconsistent with all the other modern elements of financial sector reformsRestructuring Public Sector Banks (The Hindu, May 16):PSBs account for over 70% of all troubled assets in India’s banking sector3 sets of issues: governance (composition and functioning of the board), management (selection of the CEO), and operational(resolution of NPAs, infusion of capital by the government)Governance:Bank Boards Bureau (BBB) will be set up, and it will select CEOs, Directors, and Chairmen. BBB will contain 3 former bankers, 2 eminent professionals, and the DoFS Secretary. The government must let this BBB function independentlyManagement: It has been decided that the office of the CMD will be split into two different offices; this might lead to turf wars, and the actual independent director being under the thumb of the political appointeeOperations: The PSBs performed quite well after the bank reforms in 1993, till about 2010. After that, their finances deteriorated for 2 reasons- they got into infrastructure financing in a big way,and CEOs selections went wrong in many places. Now, the government must help by adequate capital infusion, rather than insisting on banks improving their performance before they can access capital ................
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