Sequencing matters

Govt should first build its capacity to administer policy

Delivering the Fifth C D Deshmukh Memorial Lecture last week, Vijay Kelkar, veteran policy thinker and the current president of the Indian Statistical Institute, underscored some valuable principles of policymaking that the Union government would do well to incorporate at a crucial time in India’s growth story. There were two standout points he made. One, he talked about the importance of understanding “sequencing” in policymaking. When ushering in a group of inter-related reforms, it is important for the government to pay attention to not just the economic considerations but also the political economy aspects as well as the state’s capacity to implement reforms. For instance, before undertaking trade reforms a government must first put in place exchange rate reforms. That’s because, if not done in this order, the government’s management of the exchange rate in an open economy is liable to be corrupted by those exporters who stand to gain from distortions. This is exactly what happened in China. Something similar has been happening in India with regard to inflation targeting. It has not been as effective as it could be primarily because, in the absence of underlying reforms, monetary transmission in the economy has been weak.

The other big concern that the government must address is the high marginal cost of public funds. Historically, policymakers in India have been known to resort to subsidies almost as the first port of call when it comes to addressing any market failure. However, as a study by Arbind Modi, Ajay Shah and Mr Kelkar shows, the cost to society of Rs 1 of public spending is around Rs 3 — thanks essentially to the inefficiencies in the existing tax system. These include a “menagerie of bad taxes” such as cesses and taxation of inter-state commerce. In fact, the trend of steady reforms since 1991 was reversed since 2004 with the inclusion of various cesses and taxes such as the securities transaction tax. 

A combination of these two inefficiencies brings down the final policy outcome for the government. For instance, data on corporate taxation shows that while the government applies a high tax rate yet it also succumbs to lobbying and ends up providing numerous exemptions. The end result is the effective tax rate is far below the actual rate. So the government loses both on account of lower compliance (because of a high rate) as well as various exemptions. In other words, while putting in place a new policy, governments should keep it simple and learn to walk before they can run.

In the context of the goods and services tax regime, which will completely overhaul the country’s indirect tax regime, the government has an immediate opportunity to put these principles into practice. The whole point of a GST was to have a single rate – 80 per cent of the countries that introduced a GST after 1995 opted for a single rate – but as things are panning out in India there is a multiplicity of tax slabs, which, in turn, will lead to lobbying by various interest groups to be included in a lower tax bracket. This will lead to further inefficiencies in taxation and raise the marginal cost of government expenditure. The prescription then is to first build state capacity. This can be done by first having fewer tax slabs and an overall lower rate and only after the government masters this structure should it think in terms of complicating it.