Monday, January 1, 2018

Market participants game regulations, bureaucracy responds with more red-tape...

I had blogged just recently on India's private sector's collective propensity to game regulations wherever there is an opportunity and the associated bureaucratic response to err on the side of caution with restrictive regulations. 

Consider the latest example from the compensation scheme of the GST,
Goods and services tax (GST) tax returns filed for the July to September 2017 period by firms under the ‘composition’ scheme suggest there is massive tax theft by smaller taxpayers. The composition scheme is a special one to make GST filing easier for small firms; apart from simpler tax procedures, the returns have to be filed once a quarter. To that extent, the government’s plan to bring in the e-way bill and other ways to plug tax theft are quite justified. While there are roughly 15 lakh small firms registered under the composition scheme today, the number was around 10-11 lakh in September. Of these firms, around six lakh filed their returns for July-September by December 24. The total tax they paid was around Rs 250 crore. Assuming a 2% tax incidence on their turnover — it is 1% for traders, 2% for manufacturers and 5% for restaurants — this means these firms had an average turnover of Rs 2 lakh in that period, or Rs 8 lakh for the full year if you annualise the data. The problem, however, is that firms that have a turnover of less than Rs 20 lakh a year, don’t even need to pay GST or file returns. In other words, these firms are understating their returns in a big way.
Let's face this. This is not a problem at the margins - a small share of firms indulging in tax evasion. The sheer scale of evasion is staggering. It is clear that the major share of firms are complicit. In fact, not just in this case, corporate India has shown a consistent collective proclivity to game regulations to maximize illegitimate private gains. 

This story repeats. Government implements a reform. Private sector blames the reform regulations for being very restrictive. Government responds by relaxing the regulations. The private sector responds by collectively gaming the regulations to their benefit. Then why blame the government alone for excessive red tape, especially when at stake is a non-trivial share of the country's tax base?

If this is the scale of gaming, how can we blame the inspections and reporting and other requirements of the Department of Revenue from becoming more intrusive?

We forget that trust is the basis of well-functioning markets. Regulations and enforcement are built on trust, and are largely put in place as marginal deterrence - the vast majority comply on their own and only the small minority need the threat of enforcement to comply. However, when trust is consistently betrayed (or is deficient in the first place), then regulations and enforcement have to become the basis for ensuring compliance. 

In this repeat game with market participants, the bureaucrats have internalised a preference for excessive restrictions in anticipation of the inevitable deviation from businesses. 


Anonymous said...

Do you think that the behaviour of firms is due to long-time exposure to an environment, where they had to constantly find ways out of over-regulation (sometimes un-followable)?...and that rule bending tendency has seeped into finding a way out of reasonable regulations too?

Gulzar Natarajan said...

Thanks Anon for the comment. I thought about it and was careful to not draw any causality - used the term "associated".

I am sympathetic to your line of reasoning, but don't think it would have been any different. Multiple factors would have contributed to this shaping of response including the over-regulation part. But the fact is that such deviance is now pervasive.

Anonymous said...

On a more broader scale, I was wondering - how much of our governance deficit is due to the bureaucracy's institutional factors and how much of it is due to the culture/mindset of the society that makes it difficult to regulate behaviour or provide services?

I was initially of the opinion that the causes are probably a combination of both institutional and societal factors - the problem should be addressed beginning from the end of institutional factors, as people's current behaviour is only due to prolonged exposure to certain forms of governance. Once institutional constraints are addressed, people's behaviour adjusts accordingly.

But, lately, I am beginning to question this view. Maybe there's something inherent in our society that makes it hard to be governed. I wouldn't want to blame it completely on people, as it provides safe passage and alibi for politicians and bureaucrats but at least there seems to be some element of truth to the view that the broader pattern of behaviour of society is placing huge constraints on governance capacity.

Joe Midgal calls it "resistance to state penetration". As he says, almost all diverse countries faced this issue but such status quo was shattered by strong exogenous events like wars etc. It hasn't happened in case of India.

Gulzar Natarajan said...

Thanks Anon for the very interesting thoughts.

In all such situations there are likely at least two dimensions of analysis. One, the specific regulation/requirement itself. Two, its compliance.

On the latter, my view is that enforcement works only at the margins - if 80% of people comply, then it is possible to meaningfully seek to enforce the law, if not enforcement fails. I do not see such situations as examples of governance deficit. They are examples of civic capital deficit.

This makes the initial likelihood of compliance critical. In cases where the civil society is doing one thing (here informality which is completely unregulated), introducing regulations which present a disruptive break from the past (suddenly being asked to pay taxes) can be expected to face pushback in the form of skirting around compliance.

Our informal sector is massive, when compared to any other large developing country. And taxing the informal sector leaves it uncompetitive. As Shleifer and La Porta show informal sector rarely shrinks or becomes formal, but formal sector grows. So gaming is natural. The likelihood of the initial conditions being favourable for compliance is very low in such cases.

In contrast, I would say that the tax evasion among even the formal sector corporates, itself rampant, is more a reflection of governance deficit - weak state capacity has internalised the belief that you can get away by evading.

Look at things like littering, standing in a queue, coming to office on time etc. How much of it is a problem of governance deficit as against civic capital? I am inclined more to the latter.