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.

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