From Financial Express, October 30, 2012

Signs of hope for India’s economy

The latest World Bank report on the ease of doing business in 185 economies provides a mixed picture of India, but with some glimmers of hope. India’s overall rank based on a composite index has not changed from last year. It remains at 132, still firmly in the third division of the ease-of-doing-business league. But since most countries are making improvements on this front, India’s stasis in the relative rankings is consistent with some absolute improvements.

Since 2005, the greatest percentage improvements — measured in terms of distance from the global best-practice frontier—in India’s standing in various dimensions of doing business have come in getting credit, dealing with construction permits, and procedures for starting a business. But it still ranks 173rd in starting a business, and 182nd in dealing with construction permits. To the extent that what matters are the levels of various hurdles to doing business, absolute improvements are good. But low rankings matter wherever global competitiveness is an issue.

Comparisons in rankings and levels of barriers across developing countries for different aspects of doing business do not reveal any obvious patterns, or necessarily a tight link between ease of doing business and growth performance. Where India ranks close to dead last, however, is in enforcing contracts, and the major contributor to that ranking is the length of time taken. This suggests that the state of India’s judicial system, particularly with respect to contractual disputes, is a major weak spot for its business environment.

Fixing the judicial system requires a concerted effort by the central government. It has been weakly on the reform agenda, but without making much headway. The sad part of this is that the resources needed to reduce judicial delays in India are probably a fraction of those being thrown by the government at other areas of the economy.

In other cases, there is more hope, because positive change can come at the state level. A recent story in the Washington Post, by Simon Denyer, rediscovers the possibility that, despite the central government’s difficulties in moving economic reforms forward, individual states have considerable leeway to progress, and have been doing so. Arvind Panagariya, quoted in the story, reminds us that decentralisation of economic control was a major theme of the 1991 reforms—he himself is working on a major study assessing the comparative performance of India’s states. Ajay Shah, in the same newspaper story, notes the competition for investment among some states, but also the slow diffusion of lessons on best practices in governance.

Part of the problem is that even when one gets down to the state government level, decision-making is top-heavy. How a state does seems to depend on who is at the top, and discussions of good and bad performance focus on personalities, whether it is Narendra Modi, Jayalalitha, Nitish Kumar, Chandrababu Naidu, or Prakash Singh Badal. Anecdotes abound about the way in which state leaders shape the culture of administration, and set the tone for how civil servants (the elite Indian Administrative Service in particular) carry out their duties.

Of course, leadership matters, but governance at the state level can display over-centralisation, just as at the national level. Ajay Shah notes the need to devolve power to city governments, in the Washington Post story. The 74th amendment set the stage for this 20 years ago, but actual progress has been limited. One of the key problems is the lack of political autonomy, with state-level politicians and bureaucrats able to interfere too much at the local level. Another is a lack of funds.

To some extent, the lack of funds is endogenous—with local politicians finding it easier to rely on trickle-down transfers, however small and unreliable, rather than making effective decisions on taxing at the local level. The urban property tax, in particular, has been eroded by corruption in the real estate market and in local tax administration. The national and state governments need to make a concerted effort to improve the design and administration of urban property taxes, while giving cities more leeway in setting rates—as well as allowing them to piggyback on a future GST—as I argued in my last column.

As I argued earlier, getting the states to decentralise to the local level will require giving them more autonomy and revenue authority. States are exercising de facto autonomy in competing for investment, and that can be good for improving conditions for doing business, but it is important that this not lead to competitive reductions in tax effort, with the expectation that the national government will cover the gap. As the government sets up the 14th Finance Commission, rethinking the inter-governmental transfer mechanism in concert with reconfiguring tax authorities should be an important part of the commission’s mandate. The goal should be to improve marginal incentives for revenue collection at all sub-national levels of government.

From Financial Express October 18, 2012

The virtues of tax reform

Last month, I introduced the idea of virtuous growth, which includes the fairness objective of inclusive growth as well as an additional goal of building positive human values. I gave the example of local government reform in India as a practical step towards virtuous growth. Giving people more responsibility over public spending at the local level has the potential to increase the quality and level of civic engagement.

The issue of local government reform in India actually requires a rethink of India’s structure of tax authorities. Currently, the system in operation gives the Centre more tax authority than the states. Local governments have very little scope for taxing their constituents. These statements need to be qualified, of course. State and local governments in India actually tax less than their power to do so. One reason for this is that there is an elaborate system of sharing central tax revenue to the states, and state tax revenue to local governments. There is some justification for collecting taxes at higher levels of government—it can be more efficient, and less distorting of individual economic decisions. But transfers distort the revenue-raising decisions of the recipient state governments.

One way to get the efficiency advantages of higher-level government tax collection and the incentive advantages of a lower-level government tax authority is to allow piggybacking of lower-level governments on the higher-level government’s taxes. This has not really been done in India. The Constitution of India assigned different tax bases to different levels of government. For example, the Centre was given the authority to tax non-agricultural income, while the states were given the authority to tax agricultural income. This was one of the worst features of India’s tax system, since the states lacked the political will or capacity to tax farmers, even rich ones, and it also provided a route for disguising non-agricultural income and evading tax on that income.

In any case, the idea of different governments taxing the same base did take hold in India, using loopholes in the constitutional language. For example, state-level sales taxes and central excise duties were imposed on the same goods. This turned out to be very inefficient, since there was no coordination or transparency, and because one government’s taxes were imposed on values that included taxes by another government. The value added tax (VAT) system introduced in India a few years ago began to deal with this major inefficiency. The planned goods and services tax (GST) will extend the efficiency principles of the VAT to a broader array of commodities, and include services as well.

The details of the GST still need to be worked out and bargained over. Since it replaces existing taxes, the state governments, in particular, are worried about losing revenue as tax rates and tax shares are adjusted. The Centre needs to do more to sort out these problems and create a winning coalition for reform. One feature retained by the GST is likely to be fixed tax rates for the Central and state portions of the tax: the 13th Finance Commission follows the GST Task Force in recommending rates of 5% and 7%, respectively.

A piggybacking approach would allow states the possibility of increasing their individual rates up to some maximum level. One state might choose a rate of 8%, another of 7.5%, for its GST portion. The GST structure easily allows for this possibility. Piggybacking can go further. Urban and rural local governments could be allowed to add their own surcharges, up to some maximum. For example, one city might choose an additional 0.25%, another 0.5%. The point of these surcharges is that the lower-level government decides the rates. Surcharges can be determined by elected representatives or by referenda—the key idea is that, at the margin, the residents of a jurisdiction decide to tax themselves to finance public goods within their jurisdiction.

One could potentially extend piggybacking to the personal income tax, but the GST is an easier place to start, and the occasion of introducing something new like the GST can open the door for this additional innovation. The key idea is that piggybacking allows communities to make public revenue decisions at the margin, rather than relying only on transfers from a higher level government. Civic engagement should not be just about spending, but also about financing that spending. A modern information system for administering the GST would allow local surcharges to be collected and distributed. All of this is done in the US, for example.

One of the big problems in India’s governance is that individuals do not see the connection between the taxes they pay and the services the government provides. Individuals can see this connection better if they decide on taxing themselves at the margin, in small enough constituencies so that their decisions have weight. Piggybacking on a broad tax base avoids the problem of only being able to tax small activities, and reduces the cost of administering and collecting local taxes. It may even make it easier to get a consensus agreement on the GST, giving states more flexibility as well. Freedom combined with responsibility can be a virtue.