Was India’s annual budget, which was announced on February 28, a missed opportunity in terms of measures to boost investment and remove policy bottlenecks? Those who wanted finance minister P. Chidambaram to continue aggressively with policy reforms probably thought so. Others, worried about an overheated business environment, may have been relieved that he did not try to stimulate an economy that is already growing at more than 8%. While Chidambaram tinkered with taxes, reforms in banking, insurance and FDI policies did not get much attention. In contrast, education, agriculture and infrastructure got significant support. India Knowledge at Wharton spoke with faculty members at Wharton and the Indian School of Business (ISB) to discuss the implications of the budget and the impact they might have on India’s economy.
A day before Chidambaram presented his budget, India’s ruling Congress party suffered electoral routs in two key northern states of Punjab and Uttarakhand, ceding ground to the right-wing Hindu nationalistic Bharatiya Janata Party (BJP). That was sufficient to prepare businesspeople and investors to brace for a populist budget, but they hadn’t quite figured out how best to discount stock values for that exercise.
Even before Chidambaram finished his budget speech, stock markets frowned, and the benchmark Bombay Stock Exchange Sensitive Index plunged 540 points to close below the psychological threshold of 13,000. To be sure, that loss could be attributed in part to the ripple effect of a global stock market plunge the previous day, with its epicenter in the Shangai stock exchange, as Knowledge at Wharton has analyzed elsewhere. But a week after the budget, the sentiment steadily weakened, and the Sensex lost another 350 points after a brief recovery.
The budget, coming as it did on the heels of a global stock sell-off, upset investors because it increases the dividend distribution tax from 12.5% to 15%. Meanwhile, the corporate tax rate continues to push 40%. “Such taxes are not a good idea,” says Wharton professor of finance Franklin Allen, referring to the dividend distribution tax. “It may not do too much damage, given the size of the change.” The budget also made it clear that the government does not believe that IT companies need any special favors. Their exemption from a minimum tax was eliminated, and employee stock options, a popular tool for employee retention, were made taxable. Neither measure caused any rejoicing in the boardrooms of IT firms.
How does the Indian government’s approach toward managing the economy this way compare with that of its fast-growing neighbor, China? Wharton marketing professor and China expert Z. John Zhang finds India’s effectively stiffer tax regime counter-intuitive in the current context. “Normally, as the economy grows you don’t increase the tax rate,” he says. “The Chinese experience has been to lower the tax rate.” With India’s latest budget, a common observation is that Chidambaram has taken the economy’s growth for granted, and that it needs no further prodding, at least for now.
Long-term investors are not disillusioned with the budget, says Kaushal Aggarwal, executive vice president at Avendus Advisors, an investment bank in Mumbai. “Private equity (PE) and venture capital firms generally work from a long-term investment point of view rather than short-term gains, and therefore PE funds will not read too much into the steep fall following the budget,” he says, adding that IT and IT-enabled services firms accounted for a fifth of the $7.8 billion that PE firms invested in Indian companies last year. “While this might not stem the flow of investment into the sector it will certainly affect valuations — present and future both from a short-term and a long-term perspective.”
Focus on the Farm
In response to his critics, Chidambaram described the post-budget grumbling of Indian industry as a “fascination with the corporate sector” that ignores the needs of India’s 600 million farmers. He quoted Jawaharlal Nehru, India’s first prime minister, who said, “Everything else can wait, but not agriculture.”
Amit Bubna, a professor of economics and finance at the Indian School of Business, says that the focus on agriculture was expected, given the fact that fast-rising prices of essential food have driven up inflation in recent months. He expects some relief on inflation as a result of reduced import duties on certain essential food products. “However, the most glaring problem in the budget is that it does not allow for forward contracts in agricultural commodities such as wheat and rice,” he says. “Hindering the ability of the market to reduce price uncertainty is a disadvantage in attempts at checking inflationary pressures.”
Allen says that while inflation in food prices is an issue the budget had to factor in, a bigger problem “might be income distribution because some people are getting rich too quickly and others are either worse off or staying where they are.”
If Chidambaram’s urge to push for growth was restrained by concerns of an overheated economy and growing income disparities, Zhang says safety nets could help. “In China, income disparity is currently higher than at any time in its history — the government has tolerance for income disparity,” he says. But the Chinese government is at the same time trying to create social security nets at a minimum-subsistence level, he adds. “With [higher] economic growth, the government would have more money to spend on its social programs.”
Navigating Income Disparities
Zhang recalls former Chinese premier Deng Xiaoping’s 1982 remark to peasants — “To get rich is glorious” — and says, “That policy has worked wonders.” He explains that while governments must focus on removing income disparities, they also have to “allow people with the ability and the money to do what they can do best. If you cannot tolerate income disparity you are going to constrain growth.”
Zhang says the Indian government may also want to keep an eye on how Beijing attracts FDI. “If you look at the Chinese experience, foreign firms had a lower tax rate and an incentive to come and set up shop,” he says. Over the past two decades, China has attracted nearly $700 billion in FDI by offering foreign investors 100% income tax exemptions for two years and 50% for three years thereafter. That tax party, however, is about to end soon. In the face of pressure from domestic Chinese firms — who pay a flat income tax of 33% — China is expected to level taxes at 25% for all companies, but retain for five years the tax breaks that have already been granted to foreign investors.
Speedway for Infrastructure
Chidambaram may view such tax breaks for foreign investors as being too large for comfort, but China’s head start in infrastructure development certainly helped trigger some imaginative initiatives in the Indian budget. The finance minister promised to act on a policy group’s recommendations to borrow funds from the Reserve Bank of India and lend them to Indian companies for infrastructure projects.
Another suggestion from that group that Chidambaram liked was to provide “credit wrap” insurance to help mobilize capital from international markets for infrastructure projects. Mutual funds, too, will now be allowed to operate dedicated infrastructure funds. “Like China, the Indian government now seems to be keen on doing things to have its infrastructure in place,” says Zhang. “China adopted the policy of building the nest first so that the birds will come in.”
A common feature with Indian budgets over the years has been an uncomfortable degree of seemingly random policy changes. “Ad hoc intervention continues to characterize the Indian budgetary process,” says Bubna. “It is not clear what the rationale is for lowering customs duties on umbrella parts and pet foods, or having customs duties on these products at all. Is there any reason to believe these are infant industries that need protection?”
India’s annual budget exercise has always been about more than economics; it has much to do with politics. The focus this year on agriculture, where some programs will see allocations go up more than 30%, shows that the Congress-led government would rather not repeat the experience of its predecessor. The former BJP-led administration lost power because the gains of a growing economy failed to reach many of India’s rural poor. This year’s budget aims mostly at being more “inclusive” in spreading the benefits of economic growth. In the process, the priorities of corporate interests might be sidelined for some time.