Demonetisation and GST: Reckless Decisions that Cost the Economy

Both demonetisation and GST seem to be ill-conceived notions that have had a negative impact on the Indian economy.

(Photo: Erum Gour/The Quint)

India has a rich tradition of formulating policy through public consultation and engagement with experts. Landmark projects like Green Revolution and National Rural Employment Guarantee Scheme (NREGS) were widely discussed beforehand, piloted and assessed afterwards, making the cost benefit calculations a subject matter of national scrutiny and future learning. Different waves of economic reforms during the 1990s, such as trade, tariff, foreign investment and banking reforms were preceded by widespread consultations.

An important exception has been the infamous policy of forced sterilisation during the Emergency era 1975-77. Indira Gandhi and her party paid a hefty political price for that but only after inflicting serious wounds on many poor victims.

Since coming to power in May 2014, Prime Minister Narendra Modi has promised a policy of inclusive development and ‘clean’ India: ‘Sabka Sath Sabka Vikas’ and ‘Swachch Bharat’. ‘Swachch’ also means transparent though transparency seems to be lacking in his approach to policymaking.

Also Read: Piecing Together Parts of the Demonetisation Puzzle

Demonetisation Didn’t Achieve Intended Objective

With a surprise announcement on the night of 8 November 2016 (few weeks before the crucial UP elections) Prime Minister Modi banned all Rs 500 (US$7.80) and Rs 1,000 (US$16) banknotes, invalidating 86 percent of the country’s currency in circulation. The initial stated goal was to curtail black money, counterfeit currency and terrorism. Chaos followed on the streets, the country plunged into severe currency droughts and many lives were lost.

The banking system got overwhelmed. Cash dependent informal sector suffered severe losses in employment and earnings.

Meanwhile, a much larger denomination banknote (Rs 2,000) was hurriedly introduced that provided a convenient device to store untaxed income held in cash and cast doubt on Modi’s claim that he was fighting black money. As the hope of catching crooks was fading, Modi reset the goal of demonetisation; it was now to turn India into a cashless economy.

After a brief six-month spike in digital payments, India largely returned to its previous cash-reliant self, but only after losing 1.5 percent of its GDP growth rate, or US$ 35 billion. Indeed, as critics feared, it was a huge price to pay only to discover that 99 percent of the banned notes returned home (according to RBI report, August 2017) and that digital banking will remain a pipe dream, until and unless internet connectivity radically improves, and most people have enough income to bank in the first place.

As expected, the proportion of high-value notes (Rs 500 and above) is rising again with the issuance of new notes. There is no end to counterfeit currency or terrorism either.

Policymakers Spared from Scrutiny

So far, there is no evidence of any “policy skeleton”, no prior cost-benefit analysis and no record of weighing other options. The government has not disclosed why it ignored the former RBI governor Rajan’s note against demonetisation. It is now understood that the present RBI governor, the Finance Minister of the country and PM’s own economic advisor (who is an eminent economist) were not consulted either. Demonetisation thus seems to have been the PM’s own decision – audacious, reckless and possibly recommended by quacks.

An important justification for the secrecy around the demonetisation announcement has been the need to ensure surprise so that all cash held is forced into the banking system. If, for some reason, a government drops a surprise on the country in this manner, it is obligatory in a democracy that it should face greater parliamentary and public/media scrutiny afterwards to restrain the government.

Unfortunately, this has not happened; in fact, the Prime Minister refused to participate in the parliamentary debate held on 14 December 2016, raising the possibility that any un-debated and un-thrashed out policy can be introduced on the ground that an element of surprise is necessary.

Evolution of GST

GST was launched at midnight on 1 July 2017 through a historic midnight (30 June – 1 July) session of both the houses of Parliament, emulating the celebration of Indian independence on 15 August 1947. Unlike demonetisation, GST has a history of evolution.

The reform process of India’s indirect tax regime started back in 1986 with the introduction of the Modified Value Added Tax (MODVAT), which subsequently morphed into proposals of VAT and GST.

In 1999, Prime Minister Vajpayee set up a committee headed by the then finance minister of West Bengal, economist Asim Dasgupta, to design a GST model with a single tax rate across the country. The national consultation process and the detailed design work continued through different governments and by 2010 it was 80 percent ready to be rolled out.

However, with the exit of Dasgupta in 2010 from the GST committee, the progress on the nitty gritty of the design was halted. After the Modi government came to power, the newly formed GST council under the leadership of the Union Finance Minister Mr Arun Jaitley rushed to deciding the GST rates within a year.

It now appears that most of the GST Council members are politicians and hence the bulk of the responsibility was left to the bureaucrats. While regular economic policies can be handled by finance ministry bureaucrats, a large scale GST reform ought not to have been left to them alone.

Different GST Slabs

GST ideally should be a single tax on the supply of goods and services, right from the manufacturer to the consumer ensuring that indirect tax rates and structures are common across the country, thereby increasing certainty and ease of doing business. The Centre would levy and collect Central Goods and Services Tax (CGST), and States would levy and collect the State Goods and Services Tax (SGST) on all transactions within a State, supported by a robust IT system.

Unlike most other countries, however, the GST Council in India has imposed GST at five different rates, creating anomalies across the board. For example, the GST rate is 2.5 percent for soaps and 28 percent for washing detergents; 5 percent on apparel, but 12 percent on textile items costing more than Rs 1,000.

GST on movie tickets is based on slabs, with 18 percent GST for tickets that cost less than Rs 100 and 28 percent GST on tickets costing more than Rs.100.

Some products were exempted by the government and remain untaxed under GST, such as petroleum products, dairy products, products of milling industries, fresh vegetables and fruits, meat products, and other groceries and necessities.

Finance Minister Jaitley’s explanation that GST rates were arrived at “by saddling previous taxes” and applying “principles of equivalence”, support the opposition argument that GST is just a new form of the old system.

Complex Procedure Made Integration Difficult

The procedure of registering and filing tax returns for GST is rather complex. As the system requires everybody along the supply chain to collect tax from the next stage users, file returns promptly and claim back the tax paid on the previous stage, it is imperative that the whole supply chain act in unison, and that the government issue refunds as promptly as possible; otherwise the firms would run into a serious liquidity problem.

Small and medium businesses have been suffering particularly as they face substantial fixed costs of transitioning to the new system – record keeping, hiring accountants and filing returns. On its part, the government has not been prompt in paying refunds.

Then, there is the issue of integrating the informal sector which is still recovering from demonetisation. If the whole supply chain is in the informal sector, then it might escape the GST chain altogether and theoretically can sustain the businesses uninterrupted. But as is often the case, the supply chain straddles on both the formal and informal sector.

Then the transition cost of an informal supplier or service provider (who may lack literacy) could be too high. Such suppliers may be forced out of the chain, turning to wage employment or other subsistence operations. GST formulation thus failed to have an inclusive strategy; forcing people into compliance is not the best way forward as costs mount.

Also Watch: Arun Jaitley vs Dr Manmohan Singh on Demonetisation

Policymaking Being Outsourced to Bureaucratic Fantasies

As the GST council has grappled to tackle these emerging issues, it tweaked rules to make it industry friendly, especially to ease hassles facing medium and small businesses.

In addition to rationalising rates over 100 commodities and easing the process of refund for exporters, the GST Council announced a major overhaul of rates on Friday, 10th November (in time for the Gujarat election in December 2017) that results in 178 items being flung off the top 28 percent tax bracket and placed into the 18 percent slot, and another 35 being shifted to a lower slab.

It sounds like a classic case of policy-making being ‘…outsourced to the bureaucratic fantasies’, vindicated by the revenue secretary Hasmukh Adhia’s suggestion that a complete overhaul of the tax rates is now required to reduce the burden on small and medium businesses.

Also Read: ‘Demonetisation Was for Institutional Cleansing’: Bibek Debroy

Economy in Trouble

Not unexpectedly, implementation of demonetisation and GST have inflicted serious harms on the economy. Despite manoeuvring the GDP baseline in January 2015, the GDP growth rate has dropped for five consecutive quarters. The economy grew by 5.7 percent in the first quarter of 2017-18 after growing by only 6.1 percent in the previous quarter.

The human cost of a 1.2 percentage point slowdown in GDP growth is not negligible – it is the amount that all the state and the central governments jointly spend on health and education budgets. Further the rising NPAs of the banking sector, slow or non-existent credit offtake, weak private investment and industrial activity, all point to an economy in trouble.

While GST had been hailed by most quarters as a good policy to boost the economy, multiple rates, anomalies and complex procedures involved have seriously dented the business confidence, production and exports.

Latest export data from July 2017 suggest slowdown in India’s exports when Bangladesh reported a 26.54 percent annual growth in its July exports. Exports from labour-intensive industries like garments, leather and gems and jewellery, dominated by micro, small and medium enterprises, either showed outright declines or reported anaemic growth with obvious implications for jobs.

Overall, demonetisation has squeezed the demand (especially for the informal sector) and GST has adversely affected the supply (especially for small and medium enterprises including those in the informal sector), thus raising the real possibility of a longer-term slowdown of the economy.

To summarise, the government’s frequent change of goals, its tinkering with the demonetisation rules or GST rates, reluctance to engage in public/parliamentary debate all seem to suggest that India's public policy decisions have more often been driven by political compulsions rather than by rigorous cost-benefit analysis within a framework of transparency and accountability. The forceful, reckless and hastened introduction of these policies is, thus, a departure from India’s democratic tradition.

Also Read: A Flower Farmer Cannot Go Cashless, a Year After Demonetisation

(Sarmistha Pal is a Professor of Financial Economics at the University of Surrey, UK. Udayan Roy is Professor of Economics at Long Island University’s LIU Post campus in Brookville, New York, USA. Bibhas Saha is an Associate Professor in Economics at the Durham University Business School. This is a personal blog and the views expressed above are the authors’ own. The Quint neither endorses nor is responsible for the same.)

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