Getting growth rate to go up

Better household savings rate, removing long-term capital gains tax and job creation are critical to reviving the system

By Author Durgesh Chandra Pathak   |   Published: 3rd Jul 2019   12:05 am Updated: 2nd Jul 2019   8:55 pm

The decline in the growth rate of the Indian economy has economists and the government worried. Let’s try to understand this phenomenon through the decline in the household savings rates.

Arth Samwad, a report by ‘India Ratings and Research’ revealed that household savings dropped to 16.3% of the GDP during the financial years 2012-17 from 23.6% in the financial year 2011-12. This is a big dip, which should concern us for the simple reason that savings are used in capital formation (creation of capital goods, which are used, in turn, to produce other goods).

Household savings are the largest component of gross savings in the economy. Thus, declining household savings indicate a decline in new investments and thus in the productive capacity of the economy. Why is this happening?

One of the first lessons in economics is about the circular flow of goods/services and money in the economy. Households supply their labour services in the labour market and earn income. They spend some of this income and save the remaining. This saving is supplied as financial capital in the capital market to firms that require finances to fund their operations. Firms, in turn, channel back some of the profits to the investors — a return on the savings.

This simple circular flow has some crucial insights: first, there should be sufficient jobs in the labour market so that those who are willing to work may do so; second, there should be sufficient demand in the economy for goods and services so that firms find it profitable to invest and produce.

The Indian economy is faltering on both these fronts. Unemployment is at a high as indicated by the NSSO report and the demand situation is grim. Household consumption is a function of income and wealth of the household. A depressed market has eroded people’s wealth and the declining consumption is a reflection of it. A simple indicator is the declining demand for automobiles.

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Reform Banks
Household savings will channel into the capital market mainly through two channels: indirectly through banks and directly when households buy equity or other instruments of investing in the stock market.

Let us take the case of the banking channel first. Savings deposits, as well as fixed deposits, are offering very low interest rates. This discourages small savers. Further, Indian banks have a very poor record of transmitting a rate cut by the RBI to the customers. Please check with someone who has taken a loan from banks. The interest rate is mobile only upwards while downward corrections for a rate cut by the RBI are rare.

Why don’t we have a system where the rate cuts transmit immediately to the end customer without any human interference? If this cannot be achieved, banks should be held accountable for transmitting the rate cuts and failing to do so should attract strict penalty.

In fact, these days the Indian banking system is working in a weird way: imposing charges on withdrawals of customers’ own money! Despite the widely known fact that catering to a customer at ATM is much cheaper than at the bank counter, charges are imposed if one exceeds some fixed number of withdrawals at ATM. There are charges even for cash transactions in some banks (both deposits and withdrawals) at their branches. Would not this entice people to hold more cash balances with them (recall the Keynesian theory of liquidity preference)!

Cash holdings with people are useless when it comes to capital formation for the economy. This, coupled with a very low return on savings, may be a factor in explaining the declining savings rate in the economy. Proper research is required to understand the effect of such steps by banks on saving habits of households. Is it so that the banks are trying to wipe out their losses from huge bad loans by charging small customers?

Detrimental Taxation
A lucrative option for savers is equity and other instruments of direct involvement in the capital market. With equity, we can differentiate between those who are long-term investors and those who are short-term and day-traders. Earlier, one could remain invested in quality stocks for over a year and not pay any tax on the capital gains. Investors kept their money locked in for at least one year to avoid the capital gains tax.

With the imposition of long-term capital gains tax (LTCG) in the last Budget, this option is not available any longer and everyone is behaving like short-term traders adding volatility to the markets. This could be seen as one of the major reasons to start the bear run in the market after the Budget-2018. Small investors were like buffers to the erratic vicissitude of the stock market.

With LTCG, the choice is no more between zero per cent tax versus 15% tax but is between 10% and 15% tax. This narrowed choice tempts many to buy or sell for small gains thus affecting the stability of the market. It is true that the government needs tax revenue to fund its expenditures but it is one thing to expand the tax base and another to increase the tax rates. Too much tax rate is going to be detrimental ultimately (check Laffer hypothesis).

So reviving the growth rate in the economy depends on reviving the household savings rate and two things are required for this: one, ensuring proper transmission of policy rates to the end customers and stopping tendency to generate revenue at the cost of small savers; two, put in place an incentive structure for investors by removing the LTCG. These steps combined with proper job creation efforts had a good potential to revive the economy.

(The author is Assistant Professor, Economics, Birla Institute of Technology & Science, Pilani, Hyderabad campus)