T C A Srinivasa-Raghavan: Taxing capital flows: The pros and cons

OKONOMOS/Such taxes work in the short run but not in the long run.

There has been consternation over the reserve Bank of India (RBI) governor's remark about taxing foreign institutional investor (FII) inflows.

My leader-writing colleagues in newspapers have all been sharply critical. Some said the idea itself was wrong, and a few said the timing of the remark was wrong.

Ex-civil servants have had two clear reactions. They have either said that the governor has a genuine problem on his hands that needs to be addressed; or that he should not have openly admitted there was a problem because that is not how one governs. The upper lip has to be stiff at all times.

The finance ministry, of course, has rejected the idea outright, partly on the legitimate grounds that taxation is its business and partly because it wants the stock market boom to continue because it is such an important vote of confidence in government.

Bankers are meanwhile saying that the governor is dead-right and that something "" anything, at all, please "" will have to be done to curb capital inflows.

They are pointing to the credit boom as a result of which the credit-deposit ratio is touching the mid-to-high 80s. Without a matching and sustained expansion in the real sector, this will only result in bad debts, they say.

At least two senior functionaries of the Planning Commission are seriously worried as well. They privately talk of the need to do something about participatory notes, which allow dodgy money to flow in and out.

But economists, for once, appear to have held their peace. Or, if they have a view, it has been pretty muted. Perhaps they are quietly and diligently conducting research. If so, they should go to the website given below.

It contains around 75 research papers on the debate on capital controls, though none by an Indian about India. Most of the papers are about east Asia and Latin America, probably because these are the only ones so far to have been laid low by capital flows.

The question is: is India's time coming now? I believe so, and it is only a matter of time before things start to go badly wrong.

The truth, if you are willing to face it, is that the present credit boom, riding as it is on capital inflows, is not sustainable.

The best international economists also seem to think so because the real sector reforms that are needed to make growth sustainable have been, as one of them put it, "pushed off the table" by the United Progressive Alliance (UPA) government. Without them, pop goes the weasel.

Be that as it may, it is useful to see what the experience has been with temporary capital controls. These are well described in the paper* by Carmen M Rheinhart and R Todd Smith cited below.

The authors say that policies to counter capital flows, including taxes (which need to be rather high) are very effective in the short run. "Hence, it could be argued that if the capital inflows are perceived as temporary, such policies could be useful."

In the long run, however, the policies don't seem to work. This means that the RBI and the government "" working together, for a change "" need to take a view on whether the current flows are short term or long term.

The authors also say "here may be reasons to believe that the "lack of effectiveness" of capital controls is not symmetric and that controls on inflows may be more effective than controls on outflows."

It turns out from the experience of several countries in the 1990s that "controls on inflows tend to emerge under more "normal" economic circumstances." These mostly take the form of rate of return differentials and if implemented in normal times, they are smaller than those imposed during a crisis.

They also show "that the use of capital inflow taxes to buffer temporary shocks that foster capital inflows will have fairly modest welfare effects." The finance ministry should make a note of this.

In the end, though, the decision whether or not to impose a tax on inflows is a political decision. The only question, in the current Indian context, is whether it should be left to the finance minister to decide or whether the National Advisory Council, too, should take a view on it.

*Carmen M Rheinhart and R Todd Smith: Temporary Capital Controls, http://www.stern.nyu.edu/globalmacro/acad_res/int_cap_flows_controls_papers.html