Connecting dots – Structural reforms, taxation, market disruptions and economic slowdown in India


Auto sales data of last few quarters and latest results of many consumer companies suggest that consumption growth is slowing down in India. With private investment growth not picking up for long, the burden of growth is now on government spending and exports. With government capital expenditure set to contract marginally in FY20 and slowdown in India’s export growth due to trade frictions around the world, economic slowdown is now very much visible in India and it is here to stay.  If we connect the dots, current economic slowdown is culmination of many factors related to government reforms & policies and structural disruptions in businesses.

First major economic disruption through government action came in late 2016 by way of demonetization. It suddenly withdrew 85%+ cash in circulation and thought cash in circulation gradually came back to normal, this action has broken a backbone of cash based unaccounted  economy whose aftershocks are still visible. Many sectors has seen increased formalization and better tax compliance due to steps like demonetization (which is good in long run), Indian economy is still suffering from reduced unaccounted economic activities which indirectly affects consumption part of formal economy.

Next year around in mid- 2017, government introduced the GST – another landmark indirect tax reform. Due to increase formalization because of GST, many businesses suffered in the process due to increased tax burden (which was not there in previous unaccounted cash based economy) thus affected MSME led economic activities. Further due to lower tax slabs for day to day consumption items (compare to previous taxation rates), GST reduced overall tax burden on the consumers’ items making them slightly cheaper (due to overall lower tax and availability of input tax credit), and government’s tax collection fell short of expectations putting some fiscal pressures which affected government expenditure growth.

Meanwhile, due to demonetization, formal financial savings of individuals increased which channelized into banking channels and equity & debt market through mutual funds. This resulted into a significant equity market rally particularly in a small & mid cap stocks and many of them (including many stocks with poor fundamentals) were started trading at euphoric levels. NBFCs (though debt MF schemes / easy lending by banks) got easy funding which again got channelized into real estate, consumer finance and micro finance sectors. However, lending to certain pockets of real estate (where many projects were stuck due to affordability issues, stricter RERA regulations, etc) and consumer (subprime category) by few NBFCs proven fatal for financial sectors. Due to this stress, many NBFCs started defaulting and that resulted into NBFC led liquidity crisis. Tighter lending norms also started affecting sectors like auto, housing and consumer whose growth depends on availability of finance. Reduced finance is one of the major reasons in negative growth in auto sectors.

India needs huge investments for its infrastructure development and being a current account deficit economy, India depends on significant amount of foreign capital in form remittance, FPI, FDI, ECB, etc. Plus, India’s infrastructure is largely developed through private investments, it is necessary to attract equity investment to fund India’s development. Culture of equity investment and favorable environment of foreign capital – these two are musts for India’s long term economic development. However, regressive taxation introduced in last two budgets has damaged both of them. Introduction of LTCG in budget 2018-19 has damaged attractiveness of risky equity investments. In fact, introduction of LTCG is one of the main reasons (other being economic slowdown & resultant risk aversion) for a significant corrections in price of many small and mid cap stocks. If this was not enough, government introduced super rich tax surcharges (which were also applicable to FPI individual investors investing through trust mode) and buy back tax in budget 2019-20. This has dampened animal spirit further not only for FPI but also for Indian entrepreneurs & general public. India has now become a high tax country where triple taxation (income tax of company, dividend/buyback tax, and super rich taxes) reaches to 60%+ for ultra HNI & entrepreneurs.

Another landmark reform of current government is introduction of bankruptcy code with an aim to speed up resolution of NPAs choking banking sector growth. However, India has yet to master the process and present delays, litigation etc have slowed the NPA recovery process further creating a risk aversion among the corporate lenders. Overdose of structural reforms, curb on cash economy and regressive taxations have created a vicious environment for entrepreneurs and investors.

There are also certain structural reasons for current economic slowdown.  Penetration of many consumer items is so high that there is a little room for a significant growth. Preference for share mobility, city congestion, and technology enabled taxi aggregators have reduced propensity to own cars. E-commerce market places have reduced middlemen traders resulting in higher stress in trader middle class communities. Though e-commerce and food delivery market places have created many jobs related to delivery of goods & services at door step, general skill set of employable youth is not in sync with current skilled set require in the age of digital business environment, resulting into unemployment due to job skill mismatch.

If timely actions were not taken, current economic slowdown has potential to deteriorate further. Certain confidence building measures (CBMs) are required to halt slowdown in certain sectors and ignite dampened animal spirit of investors and entrepreneurs. Government should at least roll back the regressive tax measures affecting foreign investors taken in recent budget. Government should announce stimulus for auto sectors through combination of GST rate cuts and fiscal incentives. Income support scheme announced for farmers in last budget coupled with normal monsoon will help reviving rural demand. In global deflationary environment where yield on most of the developed economies are in negative territory, a proper tax incentive scheme for foreign investors looking for yield based investment from infrastructure sector can attract much needed capital required for India’s infrastructure development. RBI also has a room to significantly reduce rate further due to slowing growth and deflationary demand environment, and due to excess system liquidity, interest rate transmission seems possible this time unlike in past. Excess reserve held by RBI can be transferred to government for productive use and can provide much required stimulus for the slowing economy. These CBMs should be announced or implemented as early as possible to stop economic slowdown and revive animal spirit of economic stakeholders, otherwise historical second term win of Modi – Modi 2.0 will be a lost opportunity.

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