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Budget blues for India's
FDI
By Kunal Kumar Kundu
When one talks of foreign investment in
India, it is the massive inflow of foreign
institutional investors' (FII) funds that hog the
limelight, with foreign direct investment (FDI)
continuing to play second fiddle. In the case of
China, it's the opposite. The greater attraction
of the Indian market for portfolio investors as
compared to FDI can be explained by the relative
ease with which fund managers can enter and exit
the Indian market.
It's easy for an FII to
enter the capital market. Registration with the
Securities and Exchange Board of India (SEBI)
preceded by a fairly perfunctory due diligence is
all it takes before an FII can enter the Indian
stock market and start trading. Exiting is equally
as simple. For FDI, however, both entry and exit
are far more difficult. Even in sectors that are
opened up to FDI on paper, problems remain on the
ground. There are innumerable clearances that need
to be obtained at the state and district levels.
There are also a number of practical hurdles, such
as infrastructure bottlenecks, all of which make
entry difficult. Exit is even more complicated.
Archaic labor laws such as the Industrial Disputes
Act prohibit the closure of any company employing
more than 100 workers without obtaining prior
permission from the state government. Bankruptcy
laws are convoluted and legal processes costly and
long-winded.
No wonder portfolio inflows
into India far exceed direct investment flows. FII
flows topped US$8.5 billion last year and have
already exceeded $1 billion in the current year to
date. In contrast, FDI flows have remained stuck
in the $3-4 billion groove for the past many
years. It's just the reverse in China: while the
FDI flow into the country is in the range of $50
billion, portfolio flow is in the range of $4-5
billion.
Given that FDI is far more
beneficial to the recipient country than FII as it
entails job-creation, the big question troubling
Indian policymakers is how to replicate the
Chinese pattern. The recent Indian budget has
taken certain steps to this end, but they are
still too few. To energize FDI, it reduced the
withholding tax for royalty and the fee for
technical services from the current 20% to 10%.
But this hardly helps countries with which India
already has a Double Taxation Avoidance Agreement,
where in most cases such taxes are restricted to
10%. This would, however, benefit the non-treaty
countries and might even obviate the need for
companies in such countries to take a circuitous
route to take advantage of the differential tax
treatment.
In terms of liberalization of
FDI norms in areas like insurance, pension, retail
trading and mining, the government has reiterated
its commitment though no specific roadmap or
policy guideline has been provided because of
their political sensitivity. Such compulsions have
also been driving the government to de-link policy
announcements from the budget exercise. The
decision to open up the real estate sector was
announced just before the budget.
Some
highly awaited reform measures failed to find
mention in the budget. There were no concrete
statements on labor reforms or bureaucratic
transformation. For a country that accounts for a
miniscule portion of global trade, insertion of a
sunset clause for units in Special Economic Zones
(SEZ) made little sense. Currently a firm
operating in an SEZ that began production after
March 31, 2002 is allowed a staggered tax
deduction over a period of 10 consecutive
assessment years. This benefit will not be
available to those beginning operations after
March 31, 2009.
There are similar problems
on the taxation front. While the decision to
reduce the corporate tax rate for domestic
companies from 35% to 30% was initially lauded,
the fine print later revealed that new regulations
would make India a less attractive destination
purely from a taxation point of view. First, the
reduction in the tax rate is followed by an
increase in the surcharge from 2.5% to 10%, while
the education cess of 2% stays. As a result, the
real reduction in tax rates actually works out to
be less than 3%. The surcharge has also been
increased in case of dividend distribution tax
(DDT). Thus even the DDT will increase by close to
1%. On top of this, a fringe benefit tax (FBT) has
been introduced which will now force the companies
to pay more taxes despite a cut in corporate
taxes. This will also be a hurdle for booming
software and information technology (IT) services
companies.
FBT is a tax on benefits that
employees receive as a result of their employment.
This includes employee compensation other than
wages, tips, health insurance, life insurance and
pension plans. It covers travel benefits, gifts,
use of the employer's vehicle, holiday trips,
incentives, employer-paid educational costs,
subsidized meals, recreational facilities and
professional membership fees. Even advertising and
sales promotion expenses are included in this.
This tax is to be paid by employers and will be
assessed on the value of the fringe benefits
provided to employees or their associates. The
benefit does not have to be provided directly by
the employer in order for FBT to apply. It may
still apply if the benefit is provided by an
associate of the employer or by a third party
under an arrangement with the employer.
While virtually all companies will be
affected, the IT sector will suffer the most.
Software firms will have to shell out more money
every time they send their employees abroad. The
IT-enabled services sector will be equally hit.
Call centers have to pay 10% of the telephone
bill, which is the lifeline of this sector. FMCG
(fast moving consumer goods) firms and electronic
goods companies will also suffer as they will have
to pay 30% of their brand promotion expenses.
While the finance minister clarified after the
budget release that genuine business expenses will
not be affected, only the revised draft will say
what shape the FBT finally takes.
Another
decision rued by the industry is the substantial
reduction in depreciation benefits. Currently,
depreciation on machinery and plants is allowed at
25%. Another initial depreciation of 15% is
allowed on new machinery or plants used in setting
up a new industrial unit or in case of
installation of a new plant and machinery in an
existing industrial unit resulting in a 25%
increase in capacity. The new proposal reduces the
depreciation rate to only 15% though the initial
depreciation to be allowed is to be increased to
20%. The goal of a simple tax structure with fewer
exemptions has been cited as rationale for this
step. The argument: higher exemptions encourage
capital-intensive technology leading to lower
employment.
But critics of the policy
point out that reduction in depreciation at this
stage of economic growth is like a tax against
investment, more so in an era of fast
technological obsolescence. It has been pointed
out that India's sustained economic boom has to be
investment-led, just what the recent policy
measures may end up curbing. Is it any surprise
that FDI finds it cozier in China?
Kunal Kumar Kundu is a senior
economist with a leading bilateral Chamber of
Commerce in India. He has a Masters in Economics
with specialization in econometrics from the
University of Calcutta.
(Copyright
2005 Asia Times Online Ltd. All rights reserved.
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