Budgetary thrust to economy imperative

Despite a large-scale contraction in economic activity, some exogenous policy issues seems to have contributed to increase in tax revenues, such as allowing payment in old notes for certain class of activities, petrol pumps, advance taxes, advance TDS payment, local and municipal taxes etc. Some additional revenues were generated due to income declaration scheme

Let us analyse the effects of demonetisation on growth, both in the short run and the long run. The removal of 85 per cent of the currency from circulation has resulted in severe contraction in money supply in the economy.Theoretically, in an economy, where banking and non-cash instruments are not well-developed, this massive shock may cease the transactions at once and create a chaotic situation.

As people deposited the money in banks, banks coffers are filled with huge liquidity. Due to liquidity effect, interest rates fall. Here, two channels are possible. One, by taking advantage of low interest rates, rapid credit expansion and investment need to take place. The higher investment potentially leads to higher economic activities and, ultimately, higher growth rates. But, on the other hand, if credit takeoff does not happen, then we will have a tough time. Theoretically, investments depend on two parameters: interest rates and expectations. Even at low interest rates, if investor confidence is not revived about the economy and government, then there is less chance for higher growth.

What happened and what didn’t?
Yes, contraction in cash balances almost ceased economic transactions for a while. The effect is more severe on individuals who earned income in cash and spend it in cash and daily wage earners. At sectoral level, SIAM data shows, automobile sector sales declined18.66 per cent in December. Specifically, sales of two-wheelers and three-wheelers, which are mostly paid for in cash, declined 22.04 per cent and 36.23 per cent respectively.

According to Knight Frank data, real estate sector sales declined more than 50 per cent in the fourth quarter of 2016.Tourism and hospitality industry reported around 60 per cent drop in hotel bookings. But, the Index of Industrial Production (IIP) figures, which are yardstick for manufacturing activities, show an increase of 5.7 per cent for November 2016. It is premature to conclude anything about manufacturing until the data for December 2016 is available. On the other hand, the Nikkei India Manufacturing Purchasing Managers’ Index is reported at 49.6 in December – numbers below 50 indicate a contraction. The CMIE data show a steep fall in new project announcements. New projects have fallen from 227 new projects to 177 projects, when compared to around 50 day window before and after the demonetisation.

Liquidity effect: Thanks to “liquidity effect”, almost all the banks have reduced interest rates in the range of 0.3 to 0.9 per cent. The positive aspect here is that inflation has also fallen in December 2016 to 3.41% from 3.63% in November. Hence, the real rate of interest will be much lower. Falling interest rates, low inflation, along with some incentives from the government as part of the budget will definitely increase the investor confidence and morale. This will kick-start the growth spin-off.

When it comes to the growth story of India, RBI to IMF reduced the growth forecasts for India to around 6.6 per cent to 7 per cent. What factors led to this decrease? Mainly, economic activity compression due to demonetisation shock. But, tax revenue figures tell us a different story altogether. According to Ministry of Finance data, tax revenues increased substantially after demonetisation: Corporation tax (4.4 per cent), income tax (24.6 per cent), central excise duty (43 per cent), service tax (23.9 per cent) and customs duty (4.1 per cent).

How do we explain this contrasting situation? On one side, growth is coming down due to economic activity compression and on the other hand tax revenues are increasing. Essentially, where from the tax revenues originating?

There are three possibilities: One,the economic activities have gone up so do tax revenues. This is highly unlikely as the above data shows a contraction in economic activities. Second, tax revenues, economic activity and GDP are not related. This cannot be true, since, tax revenues are generated on the economic activities of that year. Third, the tax base is effectively captured and realised. This seems true, as tax avoidance and evasion have come down due to better capturing of transactions which were not accounted earlier. This may be due to increased use of non-cash payments.

It appears that some exogenous policy issues actually contributed to increase in tax revenues, such as allowing payment in old notes for certain class of activities, petrol pumps, advance taxes, advance TDS payment, local and municipal taxes. Some additional revenues were generated due to income declaration scheme (tax, surcharge and penalty). The fall in tax revenues due to economic activity compression has been offset by the revenues generated due to above measures.

Finally, the biggest challenge is to revive investor confidence and economic activity. This primarily depends on the government policies to create “crowding–in effect” on investment. The budget is the right occasion by way of announcing, tax incentives and -wise investment incentives. To push digital payments, along with aggressive financial literacy campaigning, elimination of transaction costs and merchant discount rate (MDR) need to be announced.

(Writer is an Economist at National Institute of Public Finance and Policy, Delhi)

A Sri Hari Naidu