New Delhi: As the chief economic adviser, Arvind Subramanian has a bird’s eye view of the Indian as well as the world economy. His views are critical in shaping the economic thought of the government. Subramanian, whose tenure as chief economic adviser has just been extended, spoke to Mint on a range of issues, including the state of the Indian economy, the underlying challenges and the cause for optimism, the mindset reset achieved with the roll-out of the goods and services tax (GST) and the changing federal polity. Edited excerpts:

India’s sovereign rating upgrade by credit rating company Moody’s Investors Service on Friday is a vindication of sorts, right?

The rating upgrade seems to have responded to the reforms we have undertaken, including GST, insolvency and bankruptcy reform, bank recapitalisation and the fact that we have maintained macroeconomic stability. I think—and I hope this is not too self-serving—that our criticism of the ratings agencies in last year’s Economic Survey for their inconsistent relative treatment of India also played a small role.

My personal view is that rating agencies do not and should not be either the motivator or the cause of government’s reform actions- CEA Arvind Subramanian

We, however, need to put sovereign ratings in perspective. My personal view is that rating agencies do not and should not be either the motivator or the cause of government’s reform actions. They are the welcome collateral consequence and affirmation of what government has done. That’s it. Ratings upgrades don’t change the underlying economic realities. Government needs now to do what it needs to do to revive credit, investment, growth, and jobs. These are the real challenges.

The finance minister, at an event in Singapore, indicated that disruptions arising from structural reforms could change the glide path to fiscal consolidation. True?

We have 6-7 months of data. Some aspects of GST receipts are still not clear. We also need to take a look at other sources of revenue, recognizing that this is an unusual year, given demonetisation and GST. We will make those assessments in a month or so which will give a better idea. The glide path for this year and the next will depend on how the data will look in a few weeks. Then we will take a call. The N.K. Singh Committee report (on fiscal consolidation) will also be part of the discussion (in the ministry ahead of budget).

What is your assessment of the present macroeconomic environment in the country?

We said this clearly in the (Economic) Survey that there have been a lot of accomplishments and so on, but I do think that a number of indicators have been pointing towards the deceleration of economic activity and some of it pre-dates the two big policy actions—(roll out of) GST and demonetisation. These two actions have to some extent weighed on the economy as well; so, part of it is maybe more structural, and part of it has been brought on by transitional factors.

My diagnosis of the structural thing is actually very simple and clear: if you look at the cross country experience after bubbles, like we had as well, you have to have a process of deleveraging. In advanced countries, they call it the balance sheet recession; ours is not so much of a recession because we are not in recession territory but it is a balance sheet under-utilization of potential.

GST and demonetisation I see as transitional negative supply and demand shocks. Since they are transitional, we will hopefully move beyond them.- CEA ArvindSubramanian

If our potential is 8-8.5%, we are growing below that, and this is clearly due to the balance sheet challenge that we identified a few years ago. It is a combination of this and a certain weakness of demand that is the diagnosis.

GST and demonetisation I see as transitional negative supply and demand shocks. Since they are transitional, we will hopefully move beyond them.

The deeper diagnosis we have is the twin balance-sheet challenge, aggravated by a weak demand; that is something which is more structural and we should try to address that.

You mentioned weak demand. Is it because of prolonged rural distress?

I think weak demand is a combination of things.

One is rural incomes—not in all sectors though but in the pulses, fruits and vegetables; we showed that real incomes in these sectors have probably declined. This is because there has been something very unusual in agriculture this year that normally when you have favourable supply shocks, prices come down; but not so much that incomes are affected. I still believe farm loan waivers are going to be deflationary because people forget that if you have to meet the FRBM (Fiscal Responsibility and Budget Management Act, 2003) limit, which government has said you have to, then you can only finance this by reducing other expenditure. If you take Uttar Pradesh for example, their budget has a 13% reduction in capital expenditure, and that is also going to take away from demand.

I still believe farm loan waivers are going to be deflationary because people forget that if you have to meet the FRBM limit...then you can only finance this by reducing other expenditure- CEA Arvind Subramanian

You also have the oil shock (when international prices fell sharply, triggering a similar fall domestically), which gave a boost to demand in the last two years, and that has also played itself out and has, in fact, now turned adverse (because prices have risen). This will reduce growth, increase inflation and the current account deficit. And, of course, the cost of capital is also very high and via costly financing squeezes, the demand for durables, and affects exporters, and small and medium enterprises are affected. All of these are weighing in on an economy that is already challenged by this twin balance-sheet problem. So, that is the deeper structural diagnosis.

The cost of capital affects demand in another way. The associated loss of competitiveness by the rupee being strong also affects export demand and import-competing sectors domestically. All of these weigh in on the economy.

But hopefully now, world growth and trade are reviving, and that should offer some offset. And hopefully the transitional shocks are also behind us.

But I think if we have to realize the full potential, then some of these demand factors have to be addressed, and the twin balance-sheet has to be addressed. And here, the recapitalisation of the public sector banks that the government has recently announced is a very critical step forward.

The twin balance-sheet issue seems to be entering a political realm. How do you fix haircuts for lenders?

In the past two Surveys, we said the way to think about this banking challenge is that there are four R’s—recognition, resolution, recapitalisation and reform.

Recognition we have made progress in the sense we know the extent of the problem, although prudence demands that we be constantly vigilant about the magnitude of the problem. Then resolution is what the IBC (Insolvency and Bankruptcy Code) and NCLT (National Company Law Tribunal) processes have embarked on. It was a terrific measure taken by the government and RBI (Reserve Bank of India), but we have to give it some time for it to work. It is not something that is going to happen overnight—it is an untested process, a work in progress.

The way to think about this banking challenge is that there are four R’s—recognition, resolution, recapitalisation and reform.- CEA Arvind Subramanian

Meanwhile, recapitalisation is a complementary measure. Remember, with the twin balance-sheet problem, resolution affects the corporate balance sheet. Once you clean it up, you create demand for spending by corporates—investment. You want to solve the other balance sheet (of banks) to the extent credit has to be supplied. So, making the banks healthier, their balance sheets healthier has to be the third problem; which is why the whole recapitalisation agenda is a very important part.

Then we have to think about the long-run reform; should we have more private sector participation—all those issues will come up. All the four R’s have to be addressed. We have made progress on the first R. Resolution, we have begun the process and now recapitalisation has begun; we will then have to ensure we use the recapitalisation effort to also undertake reforms so that the problem does not repeat itself and minimizes the perverse incentives that recapitalisation can create. Here, shrinking the fundamentally unviable banks, ensuring/creating risk assessment capability in PSBs (public sector banks), and bringing in more majority private sector ownership will be terribly important reforms.

You are optimistic about the formalization of the Indian economy gaining momentum?

I think GST and the aim of formalization is something I am optimistic about. Because what distinguishes GST is that the process of formalization is not heavy-handed; it relies on self-enforcement and, hence, more of a carrot than a stick.

We need to think more about instruments of policy that rely on incentives and voluntary compliance—build on that rather than cracking down on businesses that adds to uncertainty and raises the cost of doing business. I think that is a larger issue and mindset where we need more calibrated and less blunt instruments of policy.

What distinguishes GST is that the process of formalization is not heavy-handed; it relies on self-enforcement and, hence, more of a carrot than a stick. - CEA Arvind Subramanian

With GST, the scope of the finance bill will shrink. Do you believe this will put greater focus on government spending?

Yes, it may be that spending policy may become more salient. But expenditure is a much bigger agenda; we still are process-and-input driven rather than outcome driven. Niti (Aayog) has been trying to do a lot on this, but I think that is where we need to make progress. Because how can you really have a meaningful debate on public spending unless you know the consequences. In social or public spending, we measure what we put in, but do we have a good sense of what comes out? But that is a much bigger and long-term agenda. That is one part. And then there is the other part like transfers, UBI (universal basic income), subsidies where you start thinking—I certainly think we have made a lot of progress on subsidy rationalization, especially on petroleum, but we have not made commensurate progress on other subsides, especially fertilizer.

There is a new federal polity due to GST and the 14th Finance Commission. Right?

One hundred percent, that is a great development. If you step back and look at GST as an instrument of cooperative federalism, I think it is an astonishing institutional achievement for which the finance minister deserves enormous credit. Both for the constitutional amendment bill and then running the GST Council, all done through consensus; this is something that people don’t realize enough.

But the lesson for us is that what we have shown can happen in the area of tax, should happen in every other area of development—water, agriculture, irrigation, so many things where you need cooperative federalism. I think that is where we have to be headed next. I believe that the future of India lies in the virulent spread of cooperative and competitive federalism, with GST as the harbinger.

What we have shown can happen in the area of tax, should happen in every other area of development—water, agriculture, irrigation, so many things where you need cooperative federalism- CEA Arvind Subramanian

Social capital, particularly health and education, is one weak link. They are also state subjects.

Yes, weak social capital—health and education—and their relative neglect may well have been the original sins of our country’s economic policy. These are state subjects, but there is a lot of scope for cooperative federalism in these things as well, with the centre being more pro-active. Both cooperative and competitive federalism. I hope in the next five years we will see a GST type structure for development challenges. Health, education, power, maybe UBI, water, irrigation, agriculture, there are so many areas where we need stronger institutions of cooperative federalism.

Weak social capital—health and education—and their relative neglect may well have been the original sins of our country’s economic policy- CEA Arvind Subramanian

But how do you evolve this? Planning Commission no longer exists...

I thought that is and should be the responsibility of NITI Aayog. The NITI Aayog can be for all development issues what the GST Council has become to indirect taxes.

What are the major takeaways from GST Council’s meeting in Guwahati, besides the tax rate cuts?

The message other than that of tax rate cuts that should have come out but perhaps has not come out adequately is about the reduction in compliance burden. That is a big change.

Eligibility threshold for the composition scheme (a liberal quarterly tax payment scheme with a flat 1% rate) has been raised to Rs1.5 crore sales from Rs1 crore. Another major decision was temporary suspension of the requirement to file two forms GSTR 2 and GSTR 3. We have noticed that only about two million assessees have filed GSTR 2 (relating to purchases) while GSTR 3B (summary return) and GSTR 1 (relating to supplies) have been filed by over 5.6 million. A committee led by GSTN Chairman Ajay Bhushan Pandey will review everything relating to forms and the return filing frequency to see how the system can be made simpler and easier for everyone. A lot of simplification is still possible.

The NITI Aayog can be for all development issues what the GST Council has become to indirect taxes.- CEA Arvind Subramanian

Easing the compliance requirement is a big message from the last GST Council meeting held in Guwahati. One question we are all struggling a little bit with is about transactions between small tax payers who sell to large tax payers. Big businesses tend to not buy from small businesses in the composition scheme because the big company will not get tax credit. That will force the small business to opt for regular filing, and that opens up the question whether regular filing requirements are a bit onerous for the small tax payer.

That is something we need to reflect upon a bit more and I believe it will be part of the package that comes out when we revise the requirement of forms. We have made a lot of progress on all issues relating to transition, including IT systems, forms, compliance and policy.

Is the suspension of GSTR 2 and GSTR 3 permanent?

The idea of voluntary compliance requires invoice-matching in some way. That has to be in place at some point. We have to find the simplest and cleanest way of achieving that. For this year, some kind of matching of invoices—of what has been sold and what has been bought—has to be done at the end of the year. The requirement is that some version of GSTR 2 and GSTR 3 may have to be filed just once at the end of the year to facilitate that matching.

Do you think compliance challenges faced by MSMEs (micro, small and medium enterprises) have been addressed?

No system can be perfect from the beginning. I think we have to be watchful about MSME compliance. I would not say we have solved all problems, but we did make a lot of progress and, going forward, it is possible that new issues might come up which will need to be resolved. When we redesign the forms and the return filing schedule, the focus will be on how to make compliance even more easy for MSMEs, especially those selling to other big dealers. And we are still some way from having a system of providing expeditious refunds, especially for exporters.

From a conceptual point of view, the entire idea of ensuring compliance seems to stem from the desire to prevent misuse. Shouldn’t it be to make it easier to comply?

The broader point is well taken that the law, policy, systems, forms and the compliance requirement all should be geared towards facilitating those 90% and more who want to comply, and not be geared towards catching the few erring ones. We have learnt that while the costs of corruption are huge, so are the economic costs of going after corruption. Having said that, the question arises whether we need some form of invoice matching or not. The uniqueness in GST is that matching of invoices will be done by IT systems, not by officers. If we can have simpler ways of matching invoices, while sparing the small tax payers, I still think there is a lot of merit in invoice matching. We cannot do away with that completely. Self-compliance increases when there is some kind of monitoring. That has to be done with a light hand. Here, the light hand is that of the IT (information technology) system rather than that of a tax officer.

Policymakers have flagged the poor culture of paying taxes in the country as a mindset problem. GST is one big step to change that mindset. Do you concur?

Absolutely. The idea of self-policing and voluntary compliance is going to be a big thing. The number of people who have registered for GST, who were not there in the previous system and the number of people complying better are rising and will only rise over time. The big advantage of GST is that it does not force compliance with a heavy hand. It does it with the light hand of voluntary compliance.

What is GST’s impact on inflation?

The introduction of GST insofar as inflation is concerned has a negative effect. But to be clear, it is a one-off price level effect, not an inflation effect. In the report (the 2015 report on revenue neutral rate by a panel led by Subramanian), I had argued very strongly that in order to avoid this, if anything, one should err on the side of lower tax rates because there will be some tendency by dealers to increase prices. I think that to some extent, the CPI (Consumer Price Index) inflation data do suggest there has been some GST-type effect on prices. Difficult to quantify, but it does seem to suggest so because prices have risen a bit more than they should have, given the underlying state of the economy. Therefore, I think the reduction in tax rate on a large number of items from 28% and the tax rate cut on restaurants, should dampen that to some extent. Overall, some impact, but hopefully it will be muted by these reduced rates.

The introduction of GST insofar as inflation is concerned has a negative effect. But to be clear, it is a one-off price level effect, not an inflation effect- CEA Arvind Subramanian

After four months of rolling out GST, how close are we to original estimations of the potential tax base under the new system? Over 40% of assessees who are required to file monthly returns are not complying.

That is something we are looking at now. Going by preliminary numbers, I think we are going to be surprised on the upside. There are more GST registrants than registered assessees in the previous tax regime. Even after taking into account multiple registrations and other factors, numbers suggest the tax-base has gone up.

When will the anti-profiteering body be up and running?

I think the anti-profiteering body is more of a signal. We shouldn’t have to use it too much. First, it is only for two years. Second, there is the risk that something like this could morph into another source of harassment for the private sector. It should be seen as a symbolic measure and we shouldn’t have too much recourse to it.

Now that GST has had a good start, do you think there is greater acceptability now to the idea of bringing the excluded items such as real estate and select hydrocarbons into its ambit?

Land and real estate were on the agenda last time (before the Council) and as far as I know, they will be on the agenda next time also. It is a very good sign. There is a lot of openness for extending GST to land and real estate. Some people are open to bringing energy (electricity and select hydrocarbons) into GST as well.

Bringing electricity is important to making manufacturing more competitive. The appetite for bringing these items into GST has certainly gone up—no doubt. We need to stabilize all the systems and compliance before more decisions can be made. Tax reform is an evolutionary process. Bringing land and real estate into GST means putting spotlight on a sector housing a lot of unaccounted wealth.

There is a lot of openness for extending GST to land and real estate. Some people are open to bringing energy into GST as well- CEA Arvind Subramanian

GST will bring transparency into the sector. Coming back to the earlier point (of invoice matching), corruption is a problem, but combating corruption can also be a problem. Therefore, the lesson is that we should find less onerous ways of combating corruption. One of the properties of GST is that it encourages self-compliance.

What is the message coming through on the efficiency principle of GST based on experience so far?

I am encouraged by the clamour for simplicity. The GST Council is responding to it. It is very good dynamics. People are beginning to understand that simplicity is so important. The lessons coming out—the need for simplicity, fewer slabs and a light compliance burden—are good. Let us device all our tax laws and procedures to cater to the more than 90% who are compliant.

Are we moving towards a three-rate GST structure?

The finance minister has indicated that we will be thinking about this, going forward. We have almost cleaned up the 28% slab. There still are some items such as cement and white goods in that list. Once you clean up the 28% list, it is the nil, 5%, 12% and 18% slabs that remain. Then the question is whether you can collapse the 12% and 18% slabs into one.

If we do that, then we have a cleaner and simpler structure. It is very much on the cards. Only the timing remains to be worked out.

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