Avoiding the Low Middle-income Trap by investing in our Ability to Grow: Government must be an active investor and not just a night-watchman

The finance minister and her team have the unenviable task of preparing a budget that balances the long- as well as the short-term needs of the economy. The Indian economy has been experiencing a serious slowdown since Q4 of fiscal year 2017-18, when the quarterly GDP growth peaked at 8.1%.  Gross capital formation is yet to recover from its most recent peak of 32.6% during the fiscal year 2014-15. The pandemic has caused the economic activity to collapse, resulting in India becoming one of the worst affected emerging and developing economies during 2020.

Monetary Policy has outlived its utility, time to focus on Fiscal support that India needs

While a series of monetary and fiscal measures have helped India recover some of the lost ground, the absolute level of GDP for the first half of this year (2021-22) is still lower than that during 2018-19. One of the biggest drawbacks of the policy response during the last two years, and even earlier, was its reliance on monetary measures. The government expected RBI to do the heavy lifting by reducing interest rates and providing liquidity. Now, we are at a stage where we have excess liquidity and the interest rates at a historically low level, but investment and consumption are still struggling to grow. Consumer and business confidence is at an all-time low level.

Monetary policy was and continues to be a solution to the wrong problem.

Recognising that India is a Low Value-adding Agriculture Dependent Economy that faces significant Natural as well as Economic Uncertainty

One of the main reasons for India to struggle is that our policy choices are grounded in economic orthodoxy and not our reality. We are an agriculture dependent economy, where our farmers deal with natural as well as economic uncertainty. The average value-added per employed person in farming is low, as the farmers don’t get compensated for their effort and the risk/uncertainty they face. Indian businesses, particularly small and medium enterprises (MSME), do not have adequate risk capital, which limits their ability and willingness to invest in economic activities that involve taking risk and require them to deal with uncertainty.

Successive economic surveys have failed to outline this reality and have consequently created a narrative where equity market growth is confused with economic well-being.

Laying the foundations for India that does not need Income-Support for meeting Basic Needs and Subsidies for creating Low Value-adding Jobs

As many of the high frequency performance indicators suggest that the recovery is taking roots, it is time to think beyond the crisis and short-term fixes. While the target of becoming a 5-trillion economy is a nice idea for presenting at an election rally, we must have a long-term vision that focuses on becoming an innovative, high value-adding society where households and businesses are able to take risk and invest in their future.

We must envision to build an economy where the business does not need subsidies for even for creating low value-adding jobs and the households don’t need income support for meeting their basic needs.

I would like the finance minister to unequivocally state that the government would play an active role in building India’s ability to grow and not be a bystander anymore. The Indian government must use its status of risk-free borrower to invest and help people build the ability to take risk, as we have no conclusive evidence that deficit-funded public investment is bad.

Building our ability to Finance Growth, we need Debt as well as Equity

One of reasons for India being a low value-adding economy is that our production is meant for domestic consumption where average consumer is a low-earning consumer and most businesses do not have the capital required for producing high value-adding innovative products for global consumers. Since our per capita earnings are low, the per capita savings too are naturally low – limiting our ability to finance growth. Our banking system is still struggling to finance growth, as it still does not have adequate risk-capital and some the legacy issues are not yet resolved.

We must focus on improving productivity and value-addition. Productivity lowers the cost of doing business as well as the cost of living, making us cost competitive. Increased value-addition improves profitability as well enhances the business’ ability to pay a fair living wage. Once household and business (particularly MSMEs) earnings start growing consistently, the growth becomes self-sustainable.

Incentives that focus on Productivity and Value-Creation and discourage Lazy Manufacturing

I would, therefore, like the budget to link all the PLI schemes to productivity and value-addition and not just value of production. A turnover linked incentive in areas where there is no demand problem encourages lazy manufacturing, e.g., assembly of simple products like mobile phones and other low value-adding consumer products.

Building the National Innovation System that goes beyond focusing on Global Rankings 

We need to build a strong national innovation mission on the lines of Horizon Europe. A tweaking of various policies and procedures to improve global innovation rankings is of limited value. For that to happen, we need to build a national innovation system that gets our large public and private sector firms, our national laboratories, and the universities to come together and focus on building platform and general-purpose technologies.

Green energy and digital technology are the areas where we need immediate investment. It is also important that India invests in Agri-tech, which would allow us to lead the global agriculture value creation and delivery chain.

Enhanced Social Security for Rural as well as Urban India

In order to help recover from the loss of income and depletion of savings caused by the pandemic, we must continue investing in MNREGA and expand its scope to cover urban and semi-urban areas too. As for the middle-income households, it is time that we raise the maximum exemption limit and link it to inflation – lowering their direct tax burden as this group is in any case bearing the burden of increasing indirect taxes.

Let us not force our elders to take Increased Financial Risk and lower their Quality of Life

Since we don’t have a meaningful social-security system for our elderly, it is absolutely necessary that interest income is taxed at a low flat rate. Otherwise, we are either forcing our elders to invest in financial market and take more risk or letting their quality-of-life decline in every year of their post-retirement life. It is not a debt investor’s fault that RBI is having to force the policy rates to remain low and real rates to turn negative.

At this stage, the forced low rates are only robbing Peter (deposit holders) to pay Paul (big business who are main bank borrowers or have defaulted on their loans), as the businesses or households who need credit either don’t have access or are paying significant premium over the average rate.

Employment and not Income Support

Since no amount of income support or subsidies can provide dignity to an individual, it is time that the government invests in employment creation. Education and healthcare are the two sectors where we need national missions that go beyond the election cycle announcements. Both these sectors create employment for educated youth as well as semi-skilled workers. In the medium run, India has the possibility of becoming a provider of trained teachers and healthcare professionals to the world.

Reorient our Resource Mobilisation Strategy: Incentivise Investment and not Speculative Investment

During the last decade, the tax revenue (for state and central government together) as % of GDP has become stagnant between 16 to 17% of GDP, and we are relying on indirect taxes for raising resources. Both must change. As a first step, we must increase the holding period for long-term capital gains in the stock market from one year to three years or even five years, if we truly believe that equity markets help provide long-term capital for business. A trader who is riding growth tail winds in the equity market does very little for the economy and therefore does not deserve a lower tax rate for a largely speculative investment.

Increase Progressiveness in the Indirect Tax Structure

At the same time, we need to rationalize the indirect tax structure where we introduce a higher degree of progressiveness and not burden an average household through increases in tax rate on basic consumption goods and services like petrol and diesel, health insurance, etc.

Uncertainty is the Source of Profit, but it can also cause anxiety and result in stalling an Economy, as we have seen in the past

In an uncertain economic environment, the business leaders tend to stay away from investing for the long-term and consumers curtail their demand to bare necessities, thereby causing the growth to be stalled. Quality of employment too declines, resulting in the increased share of low-paying temporary or contract jobs.

It is, therefore, imperative that the government invests in areas that help create value-adding jobs with consistent earnings.

Investment in economic and social infrastructure and incentives for production and consumption must help raise the level of earnings and reduce their volatility for households as well as the business.

The finance minister and her team have the unenviable task of preparing a budget that balances the long- as well as the short-term needs of the economy. The Indian economy has been experiencing a serious slowdown since Q4 of fiscal year 2017-18, when the quarterly GDP growth peaked at 8.1%.  Gross capital formation is yet to recover from its most recent peak of 32.6% during the fiscal year 2014-15. The pandemic has caused the economic activity to collapse, resulting in India becoming one of the worst affected emerging and developing economies during 2020.

As a result of a prolonged slowdown, followed by a collapse, India’s ability to invest and grow stands compromised. As we know, the household savings rate has been declining, employment level and workforce participation levels have been declining and business (outside of like information technology, private sector banks, etc.) has lost capital or the margins have not been going up for many years. While the government expenditure has been holding up, it has not had the courage to invest to the extent needed for supporting investment and consumption. RBI’s survey show that household and business confidence is still at its lowest level in years.

In such a situation, the government expenditure is the only way to provide a trigger for consumer confidence to come back and to accelerate growth in household and business investment and consumption.