Narendra Modi Cannot Wish India To An Economic Boom

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At his recent rally in Houston, the Indian Prime Minister Narendra Modi assured Texans and the world that everything is fine in India. He said it not just in Hindi (in which he gave his speech), but in eight other Indian regional languages, before repeating it in English for the benefit of the Americans. It was almost as if repeating it in many languages would make it true. But all is not well in India as its GDP growth rate dropped to 5 percent in the last quarter, the lowest in six years.

After partially liberalizing its markets in 1991, India became the emerging economy to beat, especially since it maintained high growth rates in the midst of the global financial crisis post-2008. But with economic blunders like demonetization, the introduction of a botched-up Goods and Services Tax (GST), and a war against India’s informal economy (where firms operate to escape taxes and regulation), the Modi government has brought the Indian economic growth miracle to its knees.

Things are so alarming that in order to provide fiscal stimulus to the economy, the government has cut corporate tax rates in India by 7 percent, bringing the effective corporate tax to 25.17 percent. While this is a welcome change, and will help firms, it is not enough to kick-start an economy that is suffering from a depression in domestic demand across all sectors. Moreover, there are concerns about what the tax cut will do to India’s fiscal deficit without the requisite cut in government spending.

Another recently announced reform is to make state-owned banks more independent. Unfortunately, the government’s policy is halfhearted and very poorly timed. It has decided to merge several state-owned banks, reducing their number from 27 to 12. While this will help badly run banks access better management and oversight, the timing could not be worse. The government has created a situation where, for the next few years, state-owned banks will be embroiled in merger and management drama instead of focusing on lending in a market that is desperate for credit.

In each of the areas crying out for structural reform like agriculture, labor, banking, and taxation, the Modi government seems to be either asleep at the wheel or tinkering without much imagination.

The looming banking crisis is because India has one of the world’s highest non-performing asset ratios, which measures the rate of default. State-owned banks, which control more than half the loans in the market, are badly managed as leadership appointments are made based on political favors. These government banks give cheap credit to well-connected cronies. Consequently, the banks have an enormous proportion of bad loans, with taxpayers picking up the bill. This problem compounds as every politician and government promises loan waivers to favored constituencies—which will worsen the problem by incentivizing others to seek loan waivers in the future. The real solution is not just merging public sector banks, but actively moving towards privatizing India’s failing banks to take control away from politicians and bureaucrats.

Similarly, the major problem in taxation has not been corporate taxes, but the GST, which is a centralized indirect tax. While bringing the country under a single system and replacing dozens of indirect taxes was laudable, India’s GST is anything but simple. It is set up for five different standard tax rates—0, 5, 12, 18, and 28 percent for the ostensible reason of taxing luxury goods differently from essentials. But cronyism set in from the very beginning and well-organized special interests managed to get special rates like 3 percent (for gold), 1 percent (for under-construction housing), and 0.25 percent (for precious gemstones). That brings the total tax rates to eight, without counting additional state-level add-ons.

Worse still is the compliance system, which initially required monthly returns in every state and the federal government, using a dysfunctional receipt matching mechanism. And to root out tax evasion, the law allows tax commissioner to summarily arrest those suspected of evasion or invoice manipulation, without provisions of anticipatory bail, implying that ordinary businesspersons were criminals. The GST has crippled smaller firms through increased compliance costs and a form of overreach known as “tax terrorism.”

To arrest the current slump in manufacturing that has plagued many sectors of the economy, the Modi government could undo this mess by swiftly simplifying the GST. This can be done by creating a single GST rate (ideally below 15 percent), reducing the filing frequency, and reducing overall compliance costs. Doing so will boost business confidence and give much-needed relief across all sectors.

Mr. Modi should move out of campaign mode and reincarnate as an economic reformer, seizing upon the chance to launch India into its next stage of reforms. Major reforms in the area of GST, labor regulation, agriculture and banking are the way to move forward. India’s dismantling of license-raj regulations and its economic liberalization in 1991 initiated a higher rate of GDP growth and lifted over 170 million Indians out of extreme poverty. But a huge task remains: about one-third of Indians—a staggering 450 million people—remain below the threshold of $3.20 a day.

India has a history of pushing through reforms only in the face of economic crisis. Unfortunately, that’s exactly what India faces today. It is now incumbent upon Modi to act swiftly and boldly.

Shruti Rajagopalan is a senior research fellow with the Mercatus Center at George Mason University.

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