The repeal of the retrospective tax was long overdue, and strongly signifies that the reformist trend in Modi 2.0 is not only continuing, but also strengthening. The institution of the tax in 2012 — it meant that the state could impose a tax on an activity ex-post, that is, the government could change the goalpost according to its fancy — was a stunner. Rumour has it that very few people in the Ministry of Finance, or outside, knew about this policy. Did PM Manmohan Singh know? Likely, but not entirely certain. Most experts believed that this policy was uniquely Indian, one befitting a country which had the word “socialism” inserted into the preamble to the Constitution some quarter century after the Constitution was written.
We were foolish to think that a retrospective tax could not happen in modern India. A year after the retro tax, it came to light that ITC had been fighting a retrospective excise tax case for 17 years, and that the Supreme Court had decided in its favour. The allegation — ITC had evaded excise taxes for four years from March 1983; it had allegedly sold cigarettes at a higher price than that printed on the packaging.
It was widely anticipated that the retro tax would be thrown into the dustbin of history (where it belonged) in the interim budget of 2014. The tax lingered till now, with assurance by the late Arun Jaitley that the Indian government would not impose any new retro taxes. Mercifully, the BJP has kept to that principled promise. In recent days, instead of losing cases in its own Supreme Court (the ITC case noted above), it has been losing in international courts (Cairn and Vodafone).
According to some critics, this delivery on a pre-2014 election promise is little more than window dressing on a tax that de facto does not exist anymore. The Modi government could easily claim that it was only following Indian law, an Act of Parliament, by pursuing the Cairn and Vodafone cases to their logical losing conclusion. So why make de facto de-jure? And why now? The reason offered by FM Nirmala Sitharaman is, “the country today stands at a juncture when a quick recovery of the economy after the Covid-19 pandemic is the need of the hour and foreign investment has an important role to play in promoting faster economic growth and employment.”
Was that the reason? Possible, but it is contradicted by the fact that India is enjoying one of the best years of foreign direct investment and foreign portfolio investment. What more could foreign investors want?
It is not just a question of what investors (domestic or foreign) want. The larger answer is that this is what Modi and his team wanted before the 2014 election, and they are holding to their promise. Not only the promise of not imposing new retro taxes, but also the promise of repeal. Like many others, I had consistently argued that a modern nation, especially a democratic nation, does not go about imposing retroactive taxes. It is bad enough that for many decades, India had one of the highest effective corporate taxes in the world. (An effective tax is simply the ratio of the tax paid to income earned. The difference between the stated nominal and the actual effective arises because of legal tax deductions). At around 27 per cent, India had one of the highest effective corporate tax rates in 2019 (and earlier). That changed in October 2019, when Sitharaman reduced corporate taxes to near world competitive levels. In parallel, after having one of the highest real policy rates in the world, the Shaktikanta Das-induced trend is for India to have a competitive real policy rate.
This march towards an internationally competitive economy needed the stamp of a tax litigation friendly regime — an empty dream with the retro-tax still a possibility. Why should investors, domestic and foreign, trust that India will no longer indulge in the unthinkable?
The end to the retro tax is a pointer of more capital reforms to come. The Commerce Department HLAG committee report was published in September 2019. That report had argued for several reforms, including some major reforms in the capital market. A long-neglected aspect of Indian exports are exports related to financial services. In 2018, Indian financial sector exports were a paltry $5 billion. Putting this in perspective is the reality that food exports from a food-deficit India in 1980 were of a higher value — $10 billion.
Major foreign investment banks enjoy one of the largest rents from participating as “monopolists” in the Indian equity markets. If rumours become reality, Indian investors will soon be able to directly buy and sell securities in foreign capital markets — and enjoy zero commissions on most trades. And no fees to financial intermediaries. These purchases will be curtailed at $2,50,000 per individual as part of the long-standing RBI Liberalised Remittance Scheme. Today, financial transactions can easily be tracked by tax authorities.
Think what would happen to portfolio inflows into India if a foreigner could purchase securities directly from the Indian capital market. Where would tax havens go? Commission rates in India will go down for all investors, including domestic. Markets will be more stable, as a collection of individual investors is unlikely to collude as big investors allegedly do. At present, the only way a foreign individual can participate in Indian markets is via the expensive high commission (low returns?) monopolistic FII route.
Another financial market reform, and one directly influenced by this goodbye to the retro tax, is that Indian sovereign (and corporate) bonds can become part of global bond indices. The cost of borrowing for governments and corporates will come down as individuals across the world invest in the now high nominal (and real) Indian yields. Today, Europe and Japan have zero nominal 10-year yields, and the US is at 1.3 per cent.
More capital will mean more investment — and more investment means higher growth. The 2020s are being defined by the US-China cold economic war. China has enjoyed superlative economic growth for three decades. There is the important stylised inverted U-shaped pattern of catch-up growth. In early stages, a country is far from the productivity frontier defined by the advanced countries. Little investment goes a long way and a country grows faster than the average GDP growth of 2 per cent of an advanced country. After the peak (of the inverted U), growth decelerates and the economy begins to approach the low productivity growth of the West.
China’s GDP growth peaked more than a decade ago. The deceleration of Chinese growth will likely increase in the coming decade. There is only one country in the world that has the scale to match China. India can enjoy a late-comer advantage for the next two decades.
But it cannot do so with a retrogressive tax regime. India needs to be trusted completely on the rule of law. The rule of law will also help privatisation and other associated best practices. This is likely the real reason why the retro tax had to be formally booted out.
This column first appeared in the print edition on August 11, 2021 under the title ‘Retro tax out, reforms in’. The writer is Executive Director IMF representing India, Sri Lanka, Bangladesh and Bhutan. The views expressed are personal and do not necessarily represent the views of the IMF, its Executive Board, or IMF management