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The Political Economy of GST

Posted by Alex M Thomas on 6th September 2017

India welcomed the Goods and Services Tax (GST) on 1st July 2017, sixty-three years after France first adopted it. In his parliament speech, Prime Minister Narendra Modi said that “GST marks the economic integration of India.” It is expected to unify India through the creation of a single market for goods and services as the GST slogan aptly captures: ‘one nation, one market, one tax’. Moreover, it is expected to increase the tax base in India where less than 1 per cent of people pay income tax and close to 90 per cent of the workers are in the informal sector. Both these perceived benefits, according to the government, are expected to accelerate India’s economic growth by making it easier to do business and increasing public investment (financed through increased tax revenue).

The second volume of Economic Survey 2016-17 released earlier last month – another first for India – argues that the introduction of GST partly contributed to “optimism about the medium term”. One hopes that the optimism is well founded and not ‘irrational exuberance’, to borrow Robert Shiller’s phrase. Was the introduction of GST aimed at raising tax compliance by simplifying the indirect tax structure with the aid of information technology? Or, did it aim to structurally reform the Indian economy with a view of increasing employment and reducing inequalities? There is also another important question to pose: is a uniform tax a good policy move in an economy like India where the intra-state and inter-state differences are significant?

Amidst his discussion on inequality, Thomas Piketty rightly writes in Capital that “Taxation is not a technical matter. It is preeminently a political and philosophical issue, perhaps the most important of all political issues.” Hence, it is important that the political economy of GST is rendered transparent. After the introduction of GST, several Indian states have lost their autonomy in public policy owing to a reduction in their tax revenue because the GST subsumes state taxes such as the value added tax (VAT), sales tax, and luxury tax. [The service tax belonged to the centre.] In fact, as GST is a destination tax, Tamil Nadu, a manufacturing state, had opposed it because of a potential revenue loss of around Rs. 9,270 crore. Additional reforms are necessary to ensure that the state’s economic policies are not throttled.

If simplification of the tax structure was a central goal, the four tax slabs of 5%, 12%, 18%, and 28% do not make sense. However, if the government has an additional goal of influencing consumer choices, different tax slabs make sense. Yet, our current GST tax structure eludes easy interpretation. For instance, why should pens be taxed at 18% and now cost more? And why should sanitary napkins be taxed at 18% and now cost more? There appears to be no obvious economic or social logic behind this classification.

On looking closer, the GST classification for goods and services appears to be based on the ‘ability to pay’ principle and therefore progressive in spirit. Hence, non-AC train travel is GST exempt while AC train travel is taxed at 5%. Similarly, while non-AC hotel services are taxed at 12%, the services in AC hotels attract a tax of 18%. From the perspective of the consumer, it is indeed the case that those who consume ‘luxuries’ (e.g., services in Five-star hotels and restaurants) have to pay a higher GST than those who consume ‘necessaries’ such as education and health services. But how are the producers affected?

During the VAT regime, handmade products were tax exempt but they are now taxed at different rates in the GST regime. If one adopts the sole principle of ‘ability to pay’ in the matter of taxation, taxing handmade products might not seem to economically unjust. As a government official put it, “a machine-made shawl is priced at Rs 500 and a handmade one at Rs 5,000. If a person can shell out so much for a handmade item, they might as well pay a higher tax on it.” This is a good example of myopic thinking because we need to ask what happens to the handloom sector (employment and wages) once the market price rises.

As I write this, a meeting has been organised to protest the taxing of handmade products. The problem is aptly captured in this statement by one of its organisers: “Handmade products such as khadi saris are already expensive as compared to machine-made products. With imposition of GST, a khadi sari has become costlier.” It is elementary economics that this can lower demand for handmade goods and negatively affect employment in this sector. India’s recycling sector has also been adversely affected due to GST implementation.

Economic policies or reforms cannot afford to be short-sighted either intentionally or out of ignorance. The second volume of the Economic Survey proudly states that the GST regime has formalised the informal textile and clothing sector. But at what cost?

It is true that the big firms will benefit from lowered transaction costs and will be able to enjoy an increased volume of inter-state business. Small firms mostly buy their inputs and sell their output within their own state. In short, the lower transaction costs benefit big firms.

While around 160 countries have implemented GST, its effects have been varied. In Malaysia, household consumption reduced after the implementation of GST; in Australia, the burden of GST was more on the poor than the rich; whereas the weaker sections of the populace benefited from GST in Ethiopia, Pakistan, and Vietnam.

To conclude, while ‘one nation, one market, one tax’ sounds alluring, it presupposes an economically homogenous nation and a uniform market for commodities and labour. Is one tax justified in India, which has several many different labour markets, each with its own ‘equilibrium’ price? Or do our policy makers think that imposing ‘one tax’ can transform India into a single market? Just like demonetisation, the GST is yet another bad economic ‘reform’ with detrimental impacts on India’s poor and vulnerable.

Acknowledgement

This is a condensed version of a talk I gave at National Public School, Indira Nagar, Bengaluru on August 11th. I thank the students for posing interesting questions. 

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Posted in Economic Policy, Economics, India, Macroeconomics | No Comments »

60 Years after the 2nd Five-Year Plan: On Economic Theory, Planning & Policy

Posted by Alex M Thomas on 18th June 2016

Picking up Ajit Dasgupta’s A History of Indian Economic Thought (1993) motivated me to revisit India’s 2nd Five Year plan (1956-61) and the Mahalanobis model in light of the structural changes in India’s economy and developments in economic theory, particularly of demand-led growth theory. Although 60 years have passed since the inception of the 2nd Five Year plan, the ‘Approach to the Second Five Year Plan’ contains ideas which are particularly important today, especially after the closure of the Planning Commission. In its place, we now have the NITI (National Institution for Transforming India) Aayog which assumes that Indian manufacturing and service sectors are currently operating ‘on a global scale’ and what is now needed is ‘an administration paradigm in which the government is an “enabler” rather than a “provider of first and last resort”’ (see Cabinet Secretariat resolution, 1 January 2015).

Why economics?

Economics is the study of commodities – its production, distribution and consumption. Economics provides us with the determinants of aggregate production (GDP), employment, and income distribution. This allows us to understand our economic surroundings better and consequently enables us to improve existing economic conditions. This may be carried out through general economic policies (for example, progressive taxation to reduce income and wealth inequalities and monetary policy to combat inflation) or through targeted economic policies (for example, fertilizer subsidies to improve agricultural productivity and tax concessions to foreign investors). Ultimately, economic interventions are made based on an assumption and several aims. The assumption is that economic theory tells us how economies function. The interventions are carried out to satisfy certain normative aims (for example, equity and freedom). This distinction is made in textbooks by distinguishing between positive and normative economics. For instance, if a particular society is not uncomfortable with unemployment its economic policies would not be aimed at reducing unemployment.

Objectives of the 2nd Five Year Plan

In this section, the economic objectives of the 2nd Five Year Plan are presented. All excerpts from the 2nd Five Year Plan are taken from here.

“The current levels of living in India are very low. Production is insufficient even for satisfying the minimum essential needs of the population….” Therefore, it was imperative to increase aggregate production. But, the economic architects of the plan did not visualize money as an end in itself.

“A rising standard of life, or material welfare as it is sometimes called, is of course not an end in itself. Essentially, it is a means to a better intellectual and cultural life. A society which has to devote the bulk of its working force or its working hours to the production of the bare wherewithals of life is to that extent limited in its pursuit of higher ends.”

Moreover, economic policy was aimed at an increase in activity levels and “also in greater equality in incomes and wealth.”

The Plan Document clearly favours social gain over private gain. In other words, private enterprise was regulated such that the economic yields benefitted all. To put it differently, a recognition of negative externalities was present.

“The private sector has to play its part within the framework of the comprehensive plan accepted by the community. … Private enterprise, free pricing, private management are all devices to further what are truly social ends; they can only be justified in terms of social results.”

More clearly,

“Economic objectives cannot be divorced from social objectives and means and objectives go together. It is only in the context of a plan which satisfies the legitimate urges of the people that a democratic society can put forward its best effort.”

The Plan Document also recognized the dual nature of urbanization – that economies of scale have both positive economic externalities and negative environmental externalities.

The 2nd Five Year Plan on economic inequality

The 2nd Five Year Plan clearly recognized that the gains from economic development are skewed and trickle down is not automatic. For the gains from economic development to be inclusive, two institutions have to be strong: trade unions and the democratic state.

“The gains of development accrue in the early stages to a small class of businessmen and manufacturers, whereas the immediate impact of the application of new techniques in agriculture and in traditional industry has often meant growing unemployment or under-employment among large numbers of people. In course of time this trend gets corrected partly through the development of countervailing power of trade unions and partly through state action undertaken in response to the growth of democratic ideas.”

There is a passage similar to Thomas Piketty’s view on wealth inequalities and the role of progressive taxation in reducing such inequalities in the document.

“The most important single factor responsible for inequalities of income and wealth is the ownership of property. Incomes from work are by no means equal, but in part at any rate, they have some justification in terms of productivity or relative scarcity. Some types of work are, however, remunerated more liberally than others for reasons which are not directly connected with productivity. Differential monetary rewards are often a matter of tradition an existing psychological or social rigidities. It has also to be borne in mind that capacity to work effectively at higher levels depends on a person’s education and training, and these are a matter of the accident of birth or circumstances. A large expansion of general and technical education for all classes of people irrespective of their paying capacity is over a period a potent equaliser. The point is that while inequalities in incomes from work have to be corrected, the case for taxation based specifically on wealth or property needs to be carefully examined.”

India needs to seriously consider a tax on wealth given the wide disparities of income and wealth. The connection between ‘productivity’ and ‘social rigidities’ is noteworthy and requires to be addressed through labour laws, education policy, food policy, employment policy and so on.

The core of the 2nd Five Year Plan: the Mahalanobis model

From the previous paragraphs, we can state the following as the normative economic aims of the 2nd Five Year Plan: (1) expansion of output and employment opportunities, (2) reduction of income inequalities, and (3) inclusive economic growth and development. The economic core of the 2nd Five Year Plan is constituted by the Mahalanobis model. As Ajit Dasgupta writes in A History of Indian Economic Thought, “The purpose of the model was to determine the optimal allocation of investment between different productive sectors so as to maximise long-run economic growth in India” (p. 164). In other words, the aim of this model is to increase the pace of aggregate economic activity in India.

The Mahalanobis model is a two-sector model with a capital goods and a consumption goods sector. The model tells us how the resources are to be distributed between these two sectors such that maximum economic growth is achieved. Note that the then production was insufficient to meet the basic needs of the Indian populace. There are inter-sectoral relations due to which one sector cannot exist (or grow) without the other. To produce consumption goods, capital goods are required. For the workers and capitalists in both sectors, consumption goods are needed. Employing the Mahalanobis model is to some extent vindicated because the model assumes “capital to be the effective constraint on output” and India lacked good physical infrastructure.

Note also that this model assumes that there are no demand constraints. As Dasgupta writes, “The higher the proportion of investment (i.e. of the current output of capital goods) that is allocated to the further production of capital goods, the higher the long-run growth rate of output” (p. 165). The dual character of investment is not clearly understood for investment creates productive capacity and is a component of aggregate demand. Logically, a solution can be found such that the addition to capacity is validated by the demand generated but it is a knife-edge equilibrium as in Harrod.

Dasgupta points out that the Mahalanobis model has been criticized “for being concerned exclusively with investment and for identifying investment with the production of capital goods” (p. 165). Yes, demand constraints and human capital investment are ignored. Another criticism of the model has been its neglect of foreign trade (p. 166). However, the model could be modified easily to account for foreign investment and consumption whereas the incorporation of demand constrains and human capital would not be easy.

Conclusion: the relevance of economic planning

Since the 2nd Five Year Plan, much time has passed and the Indian economy has undergone several changes. Developments have taken place in economic theory too, particularly in the areas of economic growth and development. While the Mahalanobis model has its limitations, the normative aims of the 2nd Five Year Plan are still valuable today. The expansion of employment opportunities needs to be at the forefront of any macroeconomic or growth strategy. As written in the 2nd Five Year Plan, “From the economic as well as from the larger social view point, expansion of employment opportunities is an objective which claims high priority”. However, NITI Aayog, the successor to the Planning Commission works within ‘an administration paradigm in which the government is an “enabler” rather than a “provider of first and last resort”’. The market cannot be expected to provide accessible and good quality education, health, housing and living environments to all. With existing economic and social inequalities, the need for economic planning is even more. Social costs require to be assessed and not ignored in the name of economic efficiency and economic growth.

An economic planner ought to know the implicit assumptions and scope of economic theories and be knowledgeable about legal and institutional constraints of policy implementation. The economic planner must therefore be an excellent economist and an experienced bureaucrat.

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Posted in Development Economics, Economic Growth, Economic Thought, Economics, Employment, GDP, India, Indian Plan Models, Macroeconomics | No Comments »

The Monopoly of Credit Rating Agencies

Posted by Alex M Thomas on 27th September 2015

“After Fitch, Moody’s lowers India’s growth forecast” reads a headline in The Hindu on August 25. Who are these agencies? They are credit rating agencies responsible for assessing the creditworthiness of big borrowers – companies and governments. The market for credit rating is dominated by 3 big firms – Standard & Poor, Moody’s and Fitch. Basically, these credit rating agencies sell information about the debtors to the creditors.

How reliable are they? As the regulator of the Indian securities market, Securities and Exchange Board of India (SEBI) writes in its FAQ, ‘A credit rating is a professional opinion given after studying all available information at a particular point of time. Nevertheless, such opinions may prove wrong in the context of subsequent events. There is no contract between an investor and a rating agency and the investor is free to accept or reject the opinion of the agency.’ As a matter of fact, the credit ratings were proven to be completely wrong in the wake of the Great Recession because they grossly misrepresented the risk on the mortgage-backed securities. Joseph Stiglitz is quoted as saying: “I view the rating agencies as one of the key culprits.” And not surprisingly, between 2001 and 2007, the operating margins of Moody’s exceeded 50 per cent, three to four times those of Exxon Mobil Corp., the world’s biggest oil company. Also, as a CFR report states, the “EU governments and ECB policymakers accused the Big Three [S&P, Moody and Fitch] of being overly aggressive in rating eurozone countries’ creditworthiness, exacerbating the financial crisis”.

A financial market mediates between debtors and creditors through the buying and selling of financial instruments with varying risk and liquidity (to meet the different preferences and needs of the market participants). Unlike in a product market, say for tomatoes, it is difficult to assess the ‘value’ (let alone the quality) of a financial instrument. Suffice to note here that different financial theories exist which provide explanations for the ‘value’ of a financial instrument. The creditor needs to know whether the debtor is credit-worthy, i.e., whether the probability of the debtor to default is low. This information need is met by the credit rating agencies, of course, not very satisfactorily. For, they also seem to fall prey to the irrational exuberance characterizing the financial markets. More importantly, as during the Great Recession, evidence points to them as perpetrating a financial crime by aiding and abetting the housing bubble by issuing top ratings to bad mortgage-backed securities.

Global investors obtain information on investment avenues from multiple sources. And in the specific case of India, most of the financial savings are parked in time deposits, Post Office savings and with LIC and not in the stock market. Should a credit rating downgrade worry us? Are we worried because of how the stock market may react? Will it affect capital inflows? Rational investors make informed decisions by examining the macroeconomic situation, the ease of investing and the transparency and stability of macroeconomic policies. For example, any amount of mere rhetoric of ‘Make in India’ will not help – as seen by the exit of Jim Rogers, a global commodities trader and hedge fund manager, from India. As Rogers’ says, “one can’t invest just on hope.”

The argument of this blog post is not that all the assessments by credit rating agencies are incorrect. The argument is rather than we must critically appraise them and contextualize them. For instance, the lowering of Asia’s growth forecasts on account of slowing exports and subdued demand by Moody’s on 8th September 2015 should be a cause for concern. Why are we not focusing on policies which generate domestic demand?

I end with the financial commentator John Kay’s observation on the power of the bond markets in Britain. “So how do bond markets acquire their power to intimidate? Politicians spend too much time talking to people who take a daily interest in the bond market, and come to believe that their obsessions are important. Britain’s economic performance should be judged by benchmarks relating to employment, productivity, growth and innovation, not credit ratings.” This should be the case in India too.

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A Review of Banik’s The Indian Economy: A Macroeconomic Perspective

Posted by Alex M Thomas on 24th June 2015

Undergraduate economics education in India relies heavily on American textbooks, especially to teach Microeconomics and Macroeconomics. So it was a welcome change to see Nilanjan Banik’s The Indian Economy: A Macroeconomic Perspective published in 2015 by Sage Publishers. It is intended to be a Macroeconomics textbook for Indian students. As Banik writes in the Preface, ‘the available standard macroeconomic textbooks have limited information about how macroeconomics works for India.’ And therefore, ‘[t]his book is for anyone who wants to clear their concepts on Indian macroeconomy.’ This blog post critically reviews (only) Chapter 1 of this book titled ‘Introducing Macroeconomics’.

Banik starts Chapter 1 with an explanation of why macroeconomics – output, employment and inflation levels – is of significance to a ‘common man’. Here, basic macroeconomic concepts and their measurement are explained. Some discussion on the evolution of growth theories is also present. Economic prosperity of common person, according to Banik, is ‘encapsulated in a higher growth rate of GDP and lower inflation and unemployment rate, since these are the factors which directly or indirectly affect his/her well-being.’ But, we must also recognise that an individual’s employment and India’s overall unemployment rate are interdependent variables, and consequently we cannot draw a simple causal line of ‘prosperity’ running from overall employment rate to an individual’s well-being. [By interdependent, I mean that the aggregate employment rate is a summation of individual employments. Not only this, but also that the magnitude and trend of aggregate employment rate often impacts the rate of investment and therefore individual employment.] And, later, on p. 19, he draws a totally reverse causal line: ‘A summation of individual well-being gives us a sense about how an economy is doing.’

Output and employment levels are determined by factors affecting aggregate supply and demand. ‘Economy-wide demand and supply conditions are aggregation of all individual market conditions.’ Is this correct? Market supply and demand curves are an aggregating of individual market supply and demand curves. But, is it legitimate to extend this argument to aggregate supply and demand? Or, is Banik here making a microfoundations argument? A macroeconomic equilibrium is characterised by the equality between planned saving and investment and therefore of aggregate supply and demand. Banik is committing the fallacy of composition in the above quoted sentence wherein aggregate demand condition is seen as an aggregation of all the individual market demand conditions.

Subsequently, Banik starts the discussion on economic growth by clarifying to the reader that the growth rate of an economy refers to the growth rate of real gross domestic product (GDP) of that economy. ‘Supply of output is determined by the availability of factor endowments such as labour, capital, organization, and technology in the economy.’ Aggregate demand is made up of consumption, investment, government and foreign demand. The full-employment level of output, as in neoclassical economics, according to Banik, is determined by supply-side factors. Therefore, it follows that supply-side policies are to be undertaken in order to increase the full-employment level of output. Hence, he writes:

‘However, any policy measure to increase the supply of output requires time. … So managing supply-side components is not that effective in the short run; however, in the long run, components such as investment in education, health-care, and physical infrastructure will have an influence over the availability of future supply of output.’ (p. 6)

What is the role for demand-side policies in this growth framework? They are employed only to take care of ‘fluctuations’ for they have no role to play in determining the full-employment level of output. This is validated by the following excerpt from Banik.

‘Demand management policies would not have been important if there was no fluctuation in demand, taking the output away from the full employment level of output.’ (p. 7)

It suffices here to note that this is a contested assertion with the contestation emerging from the research on demand-led growth.

Among historians of economic thought and economists with a historical understanding, classical economists refer to Adam Smith, David Ricardo, Robert Malthus and Karl Marx, who, while distinguishing himself from their works also employed their framework – the surplus approach to value and distribution. However, in textbooks of Macroeconomics, pre-Keynesian economics is commonly, although incorrectly, classified as classical economics; Keynes is also responsible for this confusion. Banik has a very different understanding of classical economics or as he writes, the ‘classical school of economics’. For him, it comprises ‘particularly, the Austrian school of economists led by Hayek, Robbins, and Schumpeter’ (p. 7).

On Keynes’s principle of effective demand, Banik has the following to say. ‘

Keynes tried to explain the occurrence of an event like the Great Depression through his notion of effective demand. Effective demand is the quantity of goods and services that consumers buy at the current market price. According to Keynes, economic agents behave like animals – all of a sudden becoming optimistic or pessimistic about the future. When on average, economic agents become pessimistic about the future, then consumers start spending less money, firms cut down their production, and the economy enters into recession. In Keynesian model, the emphasis is on demand-side factors.’ (p. 7)

The principle of effective demand states that aggregate activity levels are determined by aggregate demand, and that planned saving adapts to planned investment. This principle was advanced in opposition to the neoclassical Say’s law which states that supply creates its own demand. Moreover, this principle works even without having recourse to animal spirits.

Following this, Banik presents a brief overview of Samuelson’s neoclassical synthesis, Lucas’s critique, real business cycle theory and new classical approach (pp. 10-11); and, he categorises the following economists within the ‘new Keynesian group’: ‘Gregory Mankiw, Lawrence Summers, Olivier Blanchard, Edmund Phelps, and John Taylor’ (p. 12). Such a classification of economists along with the overview of different macroeconomic schools is of much value to the student readers.

After carrying out a short empirical discussion on India’s macroeconomy and empirical definitions such as consumer durables, service exports, etc, Banik makes a fallacious statement regarding the relationship between saving (S) and investment (I).

‘…in a closed economy framework … one would expect domestic savings to be the only source of investment. Accordingly, what is saved is invested and hence investment is expected to be equal to savings. In the present context, however, there is a divergence between investment and savings components of GDP. This divergence is on account of the fact that we are considering an open economy framework where we allow for foreign transactions. Typically, the more open is the economy, the more is the extent of this divergence.’ (p. 17).

In a two-sector economy (with firms and households), the accounting identity S=I holds. But, what is the explanation or theory behind this? It is the principle of effective demand: planned saving adapts to planned investment (via changes in activity levels). The mainstream neoclassical view is that planned investment adapts to planned saving (via changes in a sufficiently sensitive rate of interest). In a three-sector economy (with firms, households and a government), the accounting identity becomes: S+T = I+G, where T is taxes and G is government expenditure. And, in a four-sector economy (with firms, households, a government and the foreign sector), the accounting identity is: S+T+M = I+G+X, where M is imports and X is exports. In other words, the above 3 identities reaffirm the condition for macroeconomic equilibrium: leakages must equal injections. Thus, in equilibrium, there can be no divergence between saving and investment in a two-sector economy and in general, in equilibrium, leakages equal injections. Banik appears to be confusing macroeconomic theory with accounting identities, and disequilibrium with equilibrium positions. The above statement of Banik is therefore conceptually incorrect.

Next, he presents a commentary on growth economics, with a focus on the Harrod-Domar and Solow growth models.

‘One of the earlier works in the area of supply-side economics was independently undertaken by two economists – Roy Harrod in 1939 and Evsey Domar in 1946. The relevance of the Harrod-Domar model lies in its ability to give a dynamic flavour to the Keynesian model. The Keynesian model is a static model putting emphasis on aggregate demand and its effect on the output gap in the short run.’ (p. 21)

In the mushrooming, although at a moderate pace, research on demand-led growth, the growth model of Harrod is a seen as an early contribution to demand-led growth and not supply-side growth. It is not clear why Banik places Harrod’s contribution under supply-side economics. He goes on to point out limitations of Harrod’s model.

‘Another limitation of the model is that it assumes that labour and capital and used in equal proportions (equal prices for labour and capital).’ (p. 22).

Here, he makes yet another incorrect statement because Harrod assumed that labour and capital are used in constant not equal proportions. With this glaring error, one cannot help but wonder whether this macroeconomics textbook went through any serious internal or external reviewing. Banik then goes on to discuss the Solow model and undertakes a very brief survey of the endogenous growth models of Paul Romer, discusses the work of Robert Hall and Charles Jones on social infrastructure, and Robert Fogel’s study of the positive association between health and economic growth. Next, the author moves on to issues involved in the measurement of GDP, and in this context clarifies the meaning of operating surplus and mixed incomes.

To conclude, whilst Banik’s macroeconomics book for Indian students contains serious conceptual errors, the design of the structure of chapter one (and the others) deserves some merit. There is indeed ample scope for improvement and enlargement of the contents. Yet, it is deeply disappointing to come across the errors, such as the ones mentioned in the preceding paragraphs, in a book such as this which is stated to be an advance over existing (foreign) macroeconomics textbooks.

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