Creating new growth drivers for the economy post the IT Services boom

As the clamour for macro-economic intervention reaches a feverish pitch, Prime Minister Narendra Modi continues with many micro-economic initiatives that he hopes will aggregate to a big enough positive impact overall on the economy.

On the list are a number of initiatives in the railways, power, connectivity, roads, irrigation, digitisation, urban mass transportation etc. Several big and small measures like direct benefit transfer (DBT), demonetisation, goods and services tax (GST) etc have been either put in place or are underway to plug the leaks and wastage in the system and to mobilise resources for creating assets for common use and improving underlying efficiencies.

Incremental growth from these initiatives should begin to add up soon and together they may deliver a bigger impact than each, individually.

But, against the backdrop of a sharp fall in economic growth, in the first quarter of the year, measures like demonetisation and GST have come under severe criticism with calls for a stimulus for the economy to overcome what some see as a cyclical downturn.

A general stimulus may not be the best use of resources as observed by Sajjid Z Chinoy in his recent article. Besides exacerbating the underlying economic problems such as current account deficit (CAD) etc, it may end up achieving little by way of longer term gains.

While growth has reduced sharply in the last quarter, with demonetisation and GST as possible contributory factors, the problems of growth run deeper.

Lacking A Growth Driver

The economy today lacks a primary engine that can drive growth. For much of the last 20 plus years, IT services export acted as one of the primary drivers for growth. Generating lucrative primary and secondary jobs and driving up the demand for offices, housing, white goods, consumer goods, transportation, automobiles, travel, education, electronics, software and so on. Creating a huge multiplier effect and driving the overall growth of the economy.

There seems to be no such growth driver in play at the moment with IT services growth slowing down considerably as it enters a huge restructuring phase. Replicating the success of IT services into other service areas had limited success.

Two opportunities were lost during these years, the effect of which we are feeling now - one in building world-class infrastructure (productive assets for the economy) and two in creating global brands for products from India.

Though the demand for manufacturing goods picked up and jobs in the manufacturing sector were generated, mostly the market was taken up by foreign companies, effectively exporting many jobs to other countries. India’s famed consumption story failed to produce global brands and businesses that could create new engines for growth.

Much of the buoyancy in government revenues was wasted on growing government expenses (doling out social benefits through extremely leaky mechanisms) resulting in poor investments in infrastructure development required to break the constraints holding back the economy.

Secondary growth in the services industry was not easily transportable to the rest of the world (although it equipped people with skills that enabled them to relocate resulting in lost talent).

Merchandise exports stood at $274 billion against a targeted $900 billion by 2017registering a slow average growth rate of around 4.7 per cent. The target of $350 billion by 2020 for the IT sector is now looking rather difficult to achieve, with its growth slowing down to around 5.3 per cent.

There are a number of microeconomic factors that keep our export uncompetitive like the cost of logistics, speed, low supply of skilled labour, shortage of irrigation etc.

Fixing the infrastructure deficiencies would remove some of the constraints to growth, improve general efficiencies and will soon start providing the incremental gains which could well add up to substantial gains in the short and medium term. Longer trend growth will, however, depend on building new competencies and capacities.

In depth Work Is Necessary To build Our Competitiveness In The World’s Markets

The Prime Minister and his team are therefore right in attempting to seed future growth through missions like, StandupIndia, StartupIndia, MakeInIndia, SkillIndia, Atal Innovation Labs, cleaning up and expanding capacities in education etc. Already much time has been lost and it will be a while before these seeds start having an impact on the economy. Remember, years of positive policies, pro-active support and numerous initiatives of governments at the centre, state and in cities created the IT boom. Including tax exemptions and preferred access to resources. Such a stimulus is required for establishing the foundations of a long-term growth trend.

New opportunities have appeared in the form of the world moving to greener options for transportation and energy, digitisation of the economy, robotics, greener lifestyles etc, and we cannot afford to miss them.

The government is also right in providing the context for this work by way of initiatives such as smart cities, bullet train, rural electrification, renewable energy missions, digital India, mass urban transportation projects, defence production and modernisation, expansion of the space programme and so on.

But, mechanisms need to be worked out on how to engage the private enterprise on a large scale in these missions, especially for the small and medium sized enterprises (SMEs) and start-ups. This is no easy work but critical to creating the flow of opportunities and resources towards building new capacities and capabilities in the economy, which can act as the source of future long-term growth. It requires an overhaul of the government procurement process with a bias towards sourcing from local SMEs and start-ups and one that emphasises quality and innovation over price and risk aversion. Maybe the model being pursued by the ISRO, which is currently working with more than 400 firms (including big private enterprises and a large number of small local firms) for components, material supplies and fabrication, can provide the template for the playbook for such a mechanism.

If the government can create a vibrant market for the private enterprise to participate in these initiatives, it will be providing one of the most critical elements for seeding the creation of huge future market opportunities for the Indian enterprise.

The added benefit could result in a faster movement towards a New India.

This article first appeared on Swarajya

The fate of bolder initiatives may lie in the hands of the timid

Some friends were over for dinner and the talk took a turn towards, GST, Demonetisation, Oil prices etc. Some known Congress supporters (beneficiaries of the erstwhile corruption driven systems) and Modi haters (yes some like these are still friends with me), laughed at the idea of building infrastructure - 'where is it' - they said? 

‘The more you build flyovers the more traffic snarls you will have around them. ‘

‘So what about the metros’? I asked.

 ‘Well it is a good idea but being badly done they said. Everybody is making money hand over fist.’ - they retorted. 

‘And the oil prices, why are they so high? I’m a common man, it is affecting me’ - angry not just with demonetisation & GST but also the high price of petrol.

Now, these are people who so eloquently describe the problems India has, as they’ve been doing so for years now. Ask them for a solution and they have none. 

All that the government is doing (has done so far) is going to have a positive effect after a lag.

Meanwhile, the cynics and skeptics will look good.

My hope lies with the poorer, less educated, less vocal voters. In their hands may lie our fate to move ahead with bolder initiatives for the future or we may succumb to the short-term fixes that perpetuate the interlocking mess that we find ourselves in, now seven decades after we got the chance to determine our own destiny.

Building India’s Generative Capacities

The main stream talk on India’s economics is dominated by macro economic thinking - interest rates, liquidity, savings rate, FDI and things like that. The debate seems to have has hardly shifted from macro economic thinking to look at the underlying micro economic reality that shapes the growth trajectory and potential for the economy.

The emphasis of this government has been on better delivery of social benefits to the people and improving systemic efficiencies. This includes digitisation of the benefit delivery and transactions, to plugging leaks and wastes, cutting out the inefficiencies in running of the core services like power, railways etc., and creation of new Infrastructure like roads, rural electrification, housing etc. Things that have a positive impact on peoples lives.

These are certainly commendable objectives and the performance so far has been pretty good.

But the government needs money, a lot of it, to carry these objectives forward. So far the response to this has been around eliminating bottlenecks in FDI, plugin revenue leaks. etc. These are good short term measure, with many derived benefits to the economy over the longer run. But they are unlikely to give large enough gains for the future needs. This can only be bridged by much higher growth. It is here that the government needs to focus on microeconomic factors impacting the growth of small and mid sized businesses.

Growth and productivity problems

In Germany for example, virtually all businesses are small to medium sized - more than 99 percent. Numbering more than 3.6 million companies and providing more than 60 percent of all jobs in Germany, the “German Mittelstand” (mid sized companies) contributes almost 52% of total economic output. (The result of a very supportive government policy & support framework.)

In comparison in India, the micro enterprises (less than 10 employees) dominate with 94.9% of the SME sector. Small enterprises (10-100 employees) account for 4.9%, and only 0.2% are medium (>100 employees). SMEs in India employ 40% of the country’s workforce, almost 80 million persons. Numbering 44.8 million enterprises and contributing 17% to India’s GDP.  

All of this underlines how critical SMEs are to the goals of achieving higher investment, growth, and jobs. But clearly, there is a problem of growth and productivity here.

Low growth and productivity, not under reporting is the core problem

Take another set of statics - MSMEs with turnover of up to Rs 50 crore (Approx 8 million dollars ) accounts for only 20 per cent of the total tax collection through corporate tax though they account for 96 per cent of the total registered companies. 

The GDP contribution numbers and the tax contributions from this sector are a strong indictors that this segment is not as vibrant as it should be.

It’d be wrong to construe this as an indicator that this sector is full of unscrupulous elements and therefore must be dragged into the tax net by plugging the under reporting of their incomes. 

The truth is most businesses struggle to grow in the hostile Indian business environment and then stagnate as restrictive forces impinge on their growth. Most Indian businesses work on extremely thin margins, with one years margins/profits or just cashflows, becoming the input into the next years growth. Squeezing out taxes from them when they still have small revenues and especially cash from them in the form of advance taxes constraints their ability to reinvest in growth.

But even if we do assume for a moment that these businesses are under reporting and most of them are crooks and therefore paying very little by way of direct taxes, the fact of the the matter is that they are still generating a lot of economic activities and therefore corresponding indirect taxes. The new GST system helps plug the leakages and under reporting making this even better. 

Not doing well when it comes to making things

Take two other numbers that should concern the government. One, more than 50% of the MSMEs are into retail and trading, with less that 25% of them involved in making things (manufacturing). Second we now have a trade deficit of nearly 52bn dollars with China.

The numbers are a strong indicator that we’re not doing well when it comes to making things. Small businesses, especially manufacturing are struggling to grow for many reasons and need help. A large part of the blame has to fall on the broken eco-system, the result of a history of short sighted government policies & inadequate support for this sector. A vibrant StartUp-MSME sector is not just important to economic growth, it is strategic to our future as a nation.

Good beginning but much more is needed

Announcing the Union Budget for 2017, Finance Minister Arun Jaitley said MSMEs having revenues less than Rs 50 crore (approx 8 million USD) have been given a cut in corporate tax rate to 25%, from 30% earlier. Also, for the businesses that have turnover up to Rs 2 crore income would be presumed to be 6% of the total turnover of the assesses, instead of 8% for tax purposes (if gross receipts are received through digital means).

This make sense because it can have a larger impact without denting the government coffer much. The reason being, this sector accounts for only 20 per cent of the total tax collection through corporate tax, though they account for 96 per cent of the total registered companies. The annual revenue lost estimated due to this measure is estimated at Rs 7,200 crore (approx 1.2 bn USD).

Spelling out the rationale behind the move to reduce the tax rate on MSMEs, the finance minister said : "Medium and Small Enterprises occupy bulk of economic activities and are also instrumental in providing maximum employment to people. However, since they do not get many exemptions, they end up paying more taxes as compared to large companies. As per data of financial year 2015-16, 285,000 companies making profit of less than Rs 1 crore (about 200,000 dollars) paid effective tax rate of 30.26 per cent while 298 companies making profit above Rs 500 crores (about 85 million dollars) paid effective tax rate of 25.90 per cent."

This is good but clearly not enough.

Making more cash available for growth

Budget documents shows that in 2014-15, companies with turnover of Rs 50 crore and more accounted for 76 per cent of the total tax collected by the government. Out of this, companies with turnover of more than Rs 500 crore (approx 80 million USD) accounted for 56 per cent of the total corporate tax collected, 15 per cent by companies with turnover of Rs 100-500 crore and only 5 per cent by companies with turnover of Rs 50-100 crore (approx 8-16 million USD).

One measure the government could take to boost growth in this sector, is exempt payment of Income tax upto say a turnover of Rs 500 crores (40 million USD). That’d make a lot of money available to these businesses to reinvest in growth and innovation. 

And this won’t be without precedence. The IT services sector for years enjoyed tax free status and many local concessions to fuel its growth. Later, receiving the benefit of incrementally increasing taxes to the full extent over a 10 year period. The Indian IT industry is today estimated to reach 350bn USD by 2020. 

So why not for the SMEs? They’re just as important to create future growth and world class companies from India. If a case can be made for lower individual taxes to boost consumption surely there is a case for tax exemptions to boost investments. 

A back of the envelope calculation suggests the government foregoing 90,593 crores (about 14bn dollars a year) which would work out to around 6% of the total tax collection. Not much if it results in faster tax revenue growth in subsequent years and a more secure long term future.

And even when the business pays no income tax, it is paying by way of indirect taxes and contributing to the economy in many other ways. What this could do is give a big push to growth in this sector, adding both to government revenues and job growth.

Something the government should be happy with going into the next elections.

I will explore some more initiatives in follow up blogs that could reverse the situation and create a vibrant Start-up and MSME eco-system.