Sunday, December 28, 2008

Stimulating corporate India?

There is a striking difference between the fiscal stimulus debates in India and in the US (and most other countries). In the US and elsewhere, the stated objective of a fiscal stimulus is to manage the demand side by bringing unemployed resources back to work and by increasing the disposable incomes of people who are more likely to spend (Within this there are differences about which strategies - tax cuts or government spending - is the more effective option). In contrast, in India the stimulus measures appears to be aimed at managing the supply side, and consists of direct benefits and incentives to the producers and suppliers.

Econ 101 tells us that a fiscal stimulus works by leaving more money in the hands of people to spend, whose spending sets in motion a multiplier effect that in turn increases aggregate demand and the virtuous cycle gets initiated and sustained. There are two ways of managing this aggregate demand. The more direct way is to transfer money to consumers by way of tax cuts or tax credits, increase welfare support through enhanced unemployment insurance and food vouchers, and sustain and even increase employment by bringing the unemployed (or to be laid-off) resources to work. The indirect strategy is to cut duties and taxes so as to incentivize businesses to lower prices and maintain investments. This indirect strategy is a version of the trickle down economic policy making, so entrenched in India.

The stimulus measures announced by the Government of India, except some decisions on the real estate side (and here too the benefits are aimed more at builders than home buyers), have been mostly by way of cuts in duties and taxes aimed at either lowering the prices or propping up corporate bottom-lines. This strategy works on the premise that during a slowdown, lower prices will sustain demand and corporate tax benefits will incentivize businesses to continue their investments and keep capacity fully utilized.

Both these are questionable assumptions. I have blogged extensively (here and here) about the difficulty in passing on the benefits of such duty and tax cuts to the final consumers. Even recent examples do not give much faith for optimism. This is especially so in developing markets like in India where the prices are stickier and the price signal transmission belt is not very efficient and has many distortions. Second, as examples of Japan in the nineties and US recently shows, tax concessions to incentivize corporate investments will come up against the "rational expectations" on depressed economy which would induce businesses to postpone investments. In simple terms, these supply side measures end up stabilizing the profitability of corporate India, which claims to be have been badly affected by the downturn.

I am inclined to believe that one of the reasons why this strategy has assumed dominance (in the public realm and among policy makers) arises from the imperfections in the manner in which economic and financial market information is disseminated in India. The financial media (especially the electronic variants) and corporate opinion makers have been purveying this line of thought, to the near total exclusion of all else, because it benefits all of them directly. In fact this is a logical extension of the increasing belief among corporate India that the Government should directly intervene in their favour in the markets when faced with adverse economic headwinds (like currency appreciation, equity market declines, export drops, or other cyclical global economic trends), so as to bailout the industry.

No comments: