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The Modi government’s Achilles’ Heel

The monsoon session of parliament, which began on 21 July, is being drowned in a cacophony of politics. The Congress party has smelt blood in the Madhya Pradesh Vyapam scam and the Lalit Modi controversy that has embroiled the Rajasthan Chief Minister and the External Affairs Minister, and is digging in its heels over the Land Acquisition Bill.

The first law of politics is that parties that have the upper hand politically will not let go of the opportunity easily, never mind what damage it does to the economy. So the Congress party will not let parliament function without obtaining the heads of Shivraj Singh Chauhan and Vasundhara Raje – something the BJP is not going to oblige it with. So the land bill and GST could be casualties.

The real problem for Narendra Modi is that he needs those chief ministers more for the success of his five-year tenure than some of his own cabinet ministers, since growth and jobs depend on their ability to bring in state-level supportive reforms, especially when the Congress is blocking all legislation at the centre. If, for example, the burden of legislating sensible land acquisition laws will shift to states, Modi needs Raje and Chauhan (and some of his other CMs) more than some of his underperforming cabinet ministers.

Among his cabinet ministers, Sushma Swaraj, Nitin Gadkari, Suresh Prabhu, Manohar Parrikar and Nitin Gadkari are the clear current and potential future performers. Arun Jaitley and Smriti Irani are the underperformers. The latter are the ones that Modi needs to let go of if he wants delivery. Finance and HRD are the cornerstones of his programme to take India to a new level of growth and jobs, and he can’t afford to have weak performers here.

When the economy is in trouble, finance is the most important portfolio. If growth is still some quarters away, it is because North Block has to been slow realise what it was up against. The Modi premium on economic governance is gone, thanks to a weakened finance ministry.

Nothing illustrates this better than what is likely to happen in parliament this week. While there is a way out on the land bill – where the centre can allow states to pass their own laws – in the case of the GST the chances are we will be stuck with a bad law, thanks to Jaitley’s efforts to claim credit for introducing the “most important tax reform” ever (GST). Jaitley probably believes that half-a-loaf on GST is better than no loaf, but his political judgment in this regard is probably wrong. In the case of GST, half a loaf may do damage – to the BJP, and to the economy. Modi has nothing to thank him for if this law passes.

The three problem areas for GST are: 1) the one percent additional tax that manufacturing states like Gujarat and Tamil Nadu want to levy to avoid losing revenues when GST kicks in; 2) the exclusion of alcohol, tobacco and petro-products from GST, and 3) the high revenue-neutral rate of GST due to these exclusions.

While lingering state resistance to revenue losses may be met by Jaitley promising full compensation for five years (and not on a tapering scale where the compensation falls to 75 percent and 50 percent in the last two years), what is not being reckoned with in this push for GST in a hurry is its real cost.

Any government should know that implementing GST will involve one year of teething trouble in fixing IT bugs, standardising and frequently revising rules and procedures, and ironing out the paper work. This means 2016-17 will be a washout for GST even if the law is legislated this year.

Next, once implemented, if the revenue-neutral rate is anywhere above 20 percent, there will be a cost-push effect. When you are paying lower GST rates now on services, a sharp increase in GST to 20 percent plus will push up services inflation. Services are 60 percent of the economy. We are going to see supply-disruptions and cost-push pricing changes all through 2016-17 and 2017-18 as the ambit of GST widens. GST will settle down only in 2018-19, which means all through the run-up to the 2019 elections, we are going to hear a cacophony of angry dissent on GST.

Even worse from the BJP’s point of view, GST will bring large segments of the retail trade – a core support base for the BJP in the past – into the tax network. You are likely to hear shrill voices against GST very soon as it is about to be implemented. From traders to manufacturers, all of them will have to invest in new software and technology to comply with GST. There are only pain points in GST for the first two years.

Put another way, no government will be a hero when implementing GST. So one wonders why Jaitley believes that this is a reform that needs prioritisation politically, even if the end-result is a hybrid law with many problems.

Given the shortening political time-table after this year (we have major state assembly elections coming up in 2016 and 2017), it is worth going slow on GST right now and work towards a wider consensus where states are seen pushing for it rather than just the centre. In a federal structure, it is not good for the centre to push an idea which states believe is not that good for them.

The real problem for Narendra Modi is that he has the wrong man in the finance ministry. Arun Jaitley may be an excellent lawyer and debater, but he has not shown the sharpness required to run the finance ministry when this is the most important task before the Modi government.

The finance ministry has repeatedly goofed up. First, it produced a lousy 2014 budget. The second one this year was better and moderately reformist, but there is no clarity on how it will pan out. For example, five months out, we have not heard how corporate taxes are going to be cut next year and which tax exemptions will go to accommodate this cut.

Next, the finance ministry has produced a dangerous black money law that is draconian. It is likely to drive more people out of the country than bring them in to invest here. Appearing hard on black money through a draconian law is the worst way to bring probity in financial transactions. It will only push up the cost of corruption, not eliminate it. What works politically for Modi and Jaitley will not work economically. Governments should focus on eliminating future creation on black money and not obsess about what is already lost.

As Dev Kar, Chief Economist for Global Financial Integrity, wrote in The Indian Express last week: “In our experience, countries benefit more by curtailing the present rate of black-money creation than by trying to recover funds lost in the past. Numerous countries have found that getting back illicit funds and collecting unpaid taxes is an arduous, time-consuming and expensive task. In addition, the very real potential of punitive action on holders of such ill-gotten assets strongly discourages voluntary disclosure.”

In short, Jaitley’s law to bring back black money is going to fail.

Then we had the botched income-tax return (ITR) form that sought to obtain details about every individual’s foreign trips, among other things. Jaitley had to backtrack, but making changes after the damage is done is indicative of a lack of attention to detail.

Jaitley also showed no understanding of the importance of bank recapitalisation, till it became clear that public sector banks will neither lend more nor lower rates – both vital for restarting the investment cycle – thanks to a high proportion of bad loans on their books. This decision, of not providing adequate capital, is now being reversed, but a sharp finance minister would not have needed public prodding to discover this.

It seems that Arun Jaitley – who leads Modi’s most important ministry – is not the man for the job. It is time Narendra Modi bit the bullet and moved him even at a considerable loss of face. It does not benefit Modi to have Jaitley as FM when he has just three more budgets to go – and lots of daily hard work to do to unclog the investment cycle – before election time.

Failure to revive the economy quickly is going to cost Modi dear. Atal Behari Vajpayee’s NDA lost in 2004 because revival came too late – in the last year of its tenure. Modi cannot afford a repeat.

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kanimozhi


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