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Journalism of Courage
One slogan of the Internet age is, the Internet changes everything. A similar dictum applies in economics: globalisation changes everything. Global integration undoubtedly fits India8217;s interests of achieving high growth and poverty alleviation. But it concomitantly requires that we explicitly recognise how globalisation changes everything, and calls for new ways of thinking and doing economic policy.
In India, such conversations often begin with protests that India is a closed economy, and hence globalisation does not matter so much to us. This is an obsolete notion, given the dramatic changes which have taken place particularly in the last decade. The money that moves in and out of India 8212; both current and capital account 8212; now adds up to roughly Rs 20 lakh crore a year. This works out to roughly 60 per cent of GDP. To characterise this as insignificant is wrong. We must wake up to the realisation that we are now a highly open economy, and consequently need to start behaving like one.
These developments have far-reaching consequences. Our experience with the currency market and reserves build-up in recent years is a striking example of how we need to think in new ways. Traditionally, India had the attitude that it could pursue a target exchange rate and simultaneously have autonomy of monetary policy. But in the 1990s, we twice encountered constraints the rest of the world accepts. The 8220;impossible trinity8221; constraint asserts that trading on the currency market and trying to have a currency policy inevitably comes with a loss of autonomous monetary policy.
When RBI actively bought up dollars to try to modify the exchange rate, this led to dislocations such as high domestic money growth, fiscal stress and speculative inflows of 8220;hot money8221; into the country. In the 1960s and 1970s, which were formative years for most of us, we could have thought it possible to have a currency policy and have a monetary policy. But today, we have to realise that trading on the currency market interferes with domestic monetary policy. Globalisation constrains us. What was possible in a closed economy is not possible in an open economy. We have to decide which is more desirable for the country: monetary policy or currency policy. Most advanced countries, except for Japan, have confronted this choice, choosing to retain the power of monetary policy by giving up on currency trading. If RBI had not stopped trading on the currency market in April 2004, it would not have been possible to raise interest rates to combat inflation this month.
Another area where globalisation has major implications for policy is on the fiscal side. Globalisation means that factors of production 8212; labour and capital 8212; are mobile. A country with high rates of income tax suffers when smart people leave the country. A country with high rates of taxation of financial intermediation sees that financial intermediation leaves the country. Famous examples of this include the Japanese index futures market, and the Swedish government bond market, both of which migrated outside the home country in response to domestic policy problems.
A key principle of the globalised economy is that 8220;we cannot export taxes8221; 8212; that is, foreign buyers of local goods do not pay local indirect tax. Most countries, including Pakistan, Bangladesh and Sri Lanka, use the VAT principle, where imports are charged VAT at the point of entry, and exports are refunded all the VAT suffered on the raw materials purchased.
India8217;s exporters compete with firms in the rest of the world, which are all subject to such a modern VAT system. Our failure to build a sound VAT handicaps our exporters. Our exporters suffer from myriad 8220;cascading taxes8221;, including octroi, entry taxes and a long list of cesses and duties. These drive up costs, and dealing with multiple paper-based tax authorities increases transactions costs. When exports take place, our exporters deal with a bureaucratic system of DEPB which is ridden with difficulties.
With a higher and growing trade/GDP ratio compared to the US or Japan, India is becoming a willing globaliser. No longer are imports and exports minor sideshows in the economy. Major efficiency gains and growth opportunities would accrue to India if we place our importing and exporting companies into a modern VAT regime, just like that faced by firms in other countries. Globalisation constrains us; it has increasingly taken away our flexibility of muddling along with a conceptually flawed system of indirect taxes.
These arguments apply equally at the state level. Andhra Pradesh competes with Gujarat for investment. It also competes with the Guangdong province in south China. Globalised firms send investment to locations where they face modern fiscal systems. AP no longer has the luxury of muddling along with a conceptually flawed system of indirect taxes or state VAT. This may seem like a 8220;loss of autonomy8221; but it is the reality of the globalised world.
From 1986, we tried to meander along with incremental reforms which would move from excise towards VAT. We moved to MODVAT and CENVAT. We introduced the service tax. But the window of opportunity to make progress by small tinkering steps, without systemic reform, is increasingly closed. Besides, as India has become an open economy, the opportunity cost of tolerating an inefficient fiscal system has gone up. The end of the MFA and the enormous opportunity in textiles is just months away. Indian textile vendors will be up against Chinese competitors, who have had a sound VAT from 1994 onwards.
The 2004 Nobel prize winners, Kydland and Prescott, emphasised the importance of time-consistancy and credibility in economic policies. In a globalised economy with capital flowing in and out of the country, the need for consistency is even greater. By adapting our policy making we can reap richer dividends from globalisation.
