INDIA-BUDGET- CONCEALS A BOMBSHELL

India's ‘Do-no-evil’ Budget Conceals a Bombshell

Published: March 19, 2012 in India Knowledge@Wharton 

On Budget Day, India's cricketing superstar Sachin Tendulkar notched up his 100th 100 runs, a world record. In the newspapers the next day, he pushed Finance Minister Pranab Mukherjee's accounting exercise from the lead position. Even the business papers managed to marry the two. "On Budget day, Sachin scores," read the banner headline in The Economic Times. The DNA was equally loud: "Budget bores, Sachin scores."
The budget was considered by most to be workmanlike. It raised US$8 billion in new taxes. But the Bombay Stock Exchange Sensitive Index (Sensex), after going up some 80 points earlier in the day, ended 209 points (1%) down, indicating that the markets were expecting some action on burgeoning subsidies.
The three major subsidies -- food, petroleum and fertilizer -- stand at US$41 billion in the revised budgetary estimates for 2011-2012. On the fertilizer subsidy, the government hopes to save a considerable amount through targeting: The subsidy will flow directly to the farmer (using Nandan Nilekani's Unique ID records) instead of to the manufacturer as it does now -- a move that is expected to contain leakages in the system. On petro-products, the solution is the simplest -- raising the administered prices of diesel and cooking gas. But it is also the most difficult, as the increase is unacceptable to several allies of the government. But Mukherjee has warned that his party is ready to face a general election on this issue if its partners force it to the wall.
Setback for FDI
The budget offers little support for foreign investors or foreign direct investment (FDI). What has happened instead is a small modification that can have enormous consequences: Buried in the fine print is a clause that amends the Income-Tax Act of 1962 to allow transactions by foreign entities involving assets principally in India to be taxed locally. This means that Vodafone, which recently won a Supreme Court judgment in its favor in a case involving whether it was liable to pay taxes on a 2007 acquisition, will have to fork over US$2.2 billion.
What makes the “clarification” more far-reaching is that it is effective from April 1, 1962. That throws deals across a half-century open to the IT authorities. The government estimates that it could collect US$10 billion in additional capital gains and withholding tax. People are adding up the new dues even now and believe that the government's numbers are predicated on its going after only the big deals. Possible targets are Genpact-General Electric, Aditya Birla Nuvo-AT&T, Tata Group-AT&T, SABMiller-Foster's, and Sanofi-Aventis of France and Shantha Biotech. "It will be impossible to track all the deals," one gray-haired tax consultant noted. "The assets may have changed hands several times. Some of this happened even before I was born."
"It’s extremely negative to the FDI sentiment," notes Rohan Shah, managing partner of Economic Laws Practice, a law firm. "Vodafone had the issues decided at the very highest judicial level and everyone believed that we had attained clarity. It’s almost like the government is using the legislative route to negate the judicial process. As a legal principle, you do not normally amend a charging provision retrospectively because a person must have certainty of tax on the day he does the transaction. I expect this to be challenged, but this should not become a cat-and-mouse game. People had respect for the Indian judiciary because it took a tough and good decision. It’s very hard when your own government negates that sentiment. FDI investors will be wary because they won’t know when India may change its laws." Adds Fereshte Sethna, partner at law firm DMD Associates, which represented Vodafone in the tax case: "An era of unwarranted tax uncertainty has potentially been ushered in vis-a-vis foreign investors."
In an interview to TV channel Network 18, Mukherjee, however, justified the change in law, arguing that this had been done in the past and that it was within the government's power to make such a move. The Supreme Court had actually asked the government to "correct" the law if it wanted to tax such transactions. But the Supreme Court never said this should be done retroactively.
This issue is likely to head back to the courts as affected companies challenge the constitutionality of the move. Of course, the government may instruct the IT department to go only after future cases. (This is a part of the direct tax code being debated now.) So it could prove to be a storm in a teacup. The question is, why did the finance ministry feel compelled to do all this?
Balancing the Numbers
One reason is that the government needs the cash. Thanks to the eurozone crisis and its impact on exports and business, economic forecasts have gone awry. GDP growth in 2011-2012 is estimated at 6.9%, compared to 8.4% the previous year. The fiscal deficit has increased to 5.9% from the projected 4.6%. For 2012-2013, growth has been predicted to be 7.6% and fiscal deficit to be 5.1%. "[The deficit] is fairly reasonable," says D.E. Dogra, managing director and CEO of Credit Rating Research & Information Services. Adds Dipen Shah, head of fundamental research at Kotak Securities: "The budget is realistic in setting the target of 5.1%."
"This is not a revolutionary budget," continues Dogra. "This is a do-no-evil budget," former BSE president Ramesh Damani told a TV channel. "It's politically correct," adds a report by Infinity.com Financial Securities. The Infinity.com report points out, however, that the increase in excise (across-the-board from 10% to 12%) and bringing a large number of services into the tax net are bound to be inflationary. Inflation has been the biggest source of anxiety for the Indian economy in recent times. The Reserve Bank of India (RBI) has raised interest rates 13 times since March 2010. While inflation has been partially controlled, the net effect has been to stifle industrial growth; companies are just not going in for capital investment with debt so expensive. This is the prime reason for GDP growth coming down. But, as Mukherjee pointed out in his speech, a 6.9% expansion rate is among the highest in the world and India is still a growth driver for the world economy.
The change in excise and service tax (with exemptions and negative lists) is in a way a throwback to the past. In the pre-liberalization age, a certain category of ads would flood the daily newspapers in the days before the Union Budget. "Buy," they used to scream. "Buy before prices go up." The budget was used as an instrument to tinker with excise duties. This year, some manufacturers -- particularly in the consumer electronics arena -- seemed to have sensed a return to the old ways. The ads were back.
After the budget, fast-moving consumer goods companies announced that they would not be able to hold prices down. Automobile manufacturers indicated that hikes are inevitable. "We will have to pass on the price increase to the consumer," says Pawan Goenka, president of the automotive and farm equipment sectors at Mahindra & Mahindra. Adds Vijay Kedia, director of Atul Auto: "The automobile industry is already reeling under cost pressure. We have no choice but to raise prices soon."
J.N. Mukhopadhyay, dean of Calcutta’s Globsyn Business School and a visiting professor at the Indian Institutes of Management, offers a different perspective. "Any coalition government weighed down by populism will find it difficult to raise resources. Service tax being in the nature of expenditure tax provides a good opportunity to raise resources and bridge the fiscal deficit,” he notes.  With the fiscal deficit at an uncomfortable 5.9%, service tax could have been increased by 3% to 4% instead of 2%. With the signals that we are entering a period of monetary expansion and softening of interest rates, an increase in the corporate tax rate would have been another revenue source."
The auto industry would then have had more reason to protest. The long-sheltered IT industry is doing that now, although it has a more specific grouse."This is a missed opportunity," according to the National Association of Software and Services Companies (Nasscom)."For the US$100 billion IT-BPO sector, budget expectations largely focused on a simplified, consistent and credible policy environment that is implemented in letter and spirit. However, the fine print, some of which is still to be analyzed, has many provisions which appear retrograde, increasing discretionary powers and interpretation issues." Adds Infosys CFO V. Balakrishnan: "It is a well-balanced, pragmatic and realistic budget. But the IT industry requested some clarity and certainty on the application of tax laws." TCS CEO and managing director N. Chandrasekaran notes, “There are doses of good intentions. But [our] request to exempt SEZ (special economic zone) income from minimum alternate tax has not been granted. This is disappointing."
Positive Strokes, But Possible Storms Ahead
The budget’s focus, this time, is on three areas. "It is heartening to see that the budget addresses some key areas like education, health care and infrastructure, which are critical to national growth and development," says Naresh Wadhwa, president and country manager of Cisco India & SAARC. "Quality health care is a crying need."
During the 12th plan period, which starts this year, investment in infrastructure will go up to US$1 trillion. Half of this will come from the government and the other half from the private sector. "The focus is in keeping with India’s insatiable need for enhanced infrastructure," notes H.M. Nerurkar, managing director of Tata Steel. "India suffers from a severe infrastructure deficit and any steps that are taken toward improving it are welcome. Industries like steel should be categorized as infrastructure."
The third focus area is education. "Greater stress has been correctly given to school and vocational education," says Dhiraj Mathur, leader (education) at PricewaterhouseCoopers India. "The allocation for primary and secondary education has increased by 21% and 29% respectively. The allocation for the National Skill Development Corporation has been increased to US$200 million from US$100 million last year. Setting up the Credit Guarantee fund will improve access to higher education."
Mukhopadhyay doesn't think higher education should be ignored. "For India to reap the benefits of the demographic dividend of a young population, it is critical to allocate significant resources for both primary education and higher education. The finance minister's speech is conspicuous by the absence of stress on higher education."
But many observers say Mukherjee still has work to do. Some suggest that he is not going to be able to deliver on his deficit numbers unless he raises the price of petro-products. West Bengal Chief Minister Mamata Banerjee, an ally of the ruling Congress party, is against that. The Congress has become weaker following its poor showing in the recent elections in five states.
Signs point to stormy times ahead. The Railway Budget had been presented a few days before the Union Budget, as is the norm. Railway Minister Dinesh Trivedi is a member of Banerjee's party. In a generally-welcomed budget, he raised rail fares. Banerjee went ballistic. She said she had no idea that a fare hike was coming and that she had not been kept informed by her own party member. She has asked Prime Minister Manmohan Singh to sack Trivedi. On Sunday, Trivedi resigned. The future of the Rail Budget is uncertain.
On the issue of reforms and cutting subsidies -- on which there was nothing but some talk in this Union Budget -- there has been more talk. "We are ready to bite the bullet," says Prime Minister Singh. It may cause the government to fall and necessitate fresh elections. But, said Mukherjee in an interview with economic daily Business Standard: "We are ready to bite the ballot."