There has been a lot of debate about the impending arrival of a Rs 1 lakh car. The Tatas have been at the forefront of this little Indian contribution to the world of automobiles. I have very serious reservations about its launch. Here is why.
It is true that that a Rs 1 lakh car will help fulfill the aspirations of millions of Indians to own (and the hopes of car makers to be able to sell) a personal car. This will immediately create a massive market for cars, by some estimates nearly 100 million, and even bigger than the existing market for all categories of cars. It therefore makes great business sense for car makers to jump into the Rs 1 lakh car bandwagon. While the individual utilities of both parties to the transaction - the buyer and the seller - are surely enhanced, the sale imposes serious costs on everybody else. In other words, a sale of Rs 1 lakh car generates a negative externality.
What are the negative externalities generated by the Rs 1 lakh car? The main customer base for the Rs 1 lakh car will be those presently using two weheelers. They will be encouraged to swap their more fuel efficient two wheelers for the status conferring, but more fuel consuming cars. This straight away translates into more petrol and diesel consumption, with all its well documented environmental consequences. Greater demand for a scarce resource like petrol or diesel, we all know, generally results in higher prices. Four wheelers occupy much more traffic space, and is a recipe for exacerbating our already chronic urban traffic and parking problems. There will be more and longer traffic congestions, and average speeds in our cities will fall further. With higher travel times and greater difficulty in finding parking space, the opportunity cost of using a car will become higher than the benefits of using it.
That is not all. Taking a more macro-view, it will severely affect the two wheeler market. The two wheeler sellers and their suppliers will suffer the consequences of a fall in demand. There is another scenarion possible. The fall in demand could lead to producers lowering two wheeler prices, thereby bringing more customers into the net. This could theoretically increase sales of two wheelers. So ironically enough, we could end up with a much bigger environmental and traffic problem of more cars and more two wheelers on our roads.
Even for the car industry, this may not be a step in the right direction. Ideally any industry ought to be moving up the value chain, so as to increase profit margins. This means the car manufacturers should be trying to wean customers away from the cheaper and basic models, to the medium and higher end ones. The transition from Maruti 800 to the Matiz's, Santros and Zens, was in keeping with this expectation. But a Rs 1 lakh car will in all probability generate a race to the bottom, and could end up cannibalizing significant portions of the hitherto lower and lower-middle segments of the car market. A customer for a basic Maruti could gravitate towards the Rs 1 lakh model. Profit margins will be adversely affected, and the industry could face a crisis.
Update
Here is Tom Friedman endorsing the anti-small car club, in an NYT article, No, No, No, Don't follow us
Saturday, September 29, 2007
Friday, September 28, 2007
Interactive Guide on Housing Mortgage Bubble
There is an excellent interactive tutorial, Credit Squeeze Explained, about the housing mortgage problems across the world and how the liquidity crisis has ramifications on the global economy.
Wednesday, September 26, 2007
The Economics of Cattle
It is estimated that nearly three-fourths of the actual financial spending on self employment schemes of both the Federal and State Governments in India is spent on financing animal husbandry related activities. But is cattle rearing so profitable as to command our scarce resoruces in such an overwhelming manner, as to the exclusion of all other sectors? Figures would seem to give a different story.
Let me give you the economics of animal husbandry. We will calculate the monthly returns from a cow and a buffalo, assuming the regular Government of India's NABARD norms. The cost of a cow yielding an average 10 litres of milk or a buffalo giving an average of 8 litres is about Rs 22000. These animals require good quality green fodder and feed concentrate to maintain their high milk yields. The average monthly expenditure on a cow is about Rs 1200, whereas the income is about Rs 2750, asssuming 25 days yielding milk fetching Rs 11 for a litre. This translates into a net monthly income of Rs 1550, if the farmer purchased the cow with his own money. Now this cow is purchased by a subsidy and soft loan from a bank, which would require a monthly repayment of about Rs 700 per month, over 3 years. The net return for the farmer is now only Rs 900 per month or Rs 10,800 annually.
If we replace the cow with buffalo, the figures look even more depressing. The monthly expenditure will be about Rs 1350, and the loan repayment Rs 650. Now the buffalo requires more care, and will give milk on an average for only 20 days, though its milk fetches atleast Rs 16 per litre due to the high fat content. This amounts to a monthly income of Rs 2650 from the milk sales. The net profit now falls to just Rs 650 per month or Rs 7800 every year.
Further, there are considerable uncertainties associated with cattle rearing. In most rural areas, during summers there is severe shortage of water and green fodder, which adversely affects the milk yield. In reality, the milk yield is much less than 10 litres and 8 litres, which means the incomes are proportionately lower. The farmer and his family spends considerable time and effort, sourcing green fodder and tending to the the cattle.
It has also been found from many studies that high cattle ownership coincides with lower school enrollment ratios. Cattle rearing is a low skill, but labor intensive activity. Therefore parents find it convenient to let their children take care of the cattle rearing task, while they can concentrate on their regular livelihoods. This dis-incentivizes parents from sending their children to schools.
However, cattle ownership has another more important dimension. A cow or a buffalo is a good storage of value. The cattle can be disposed off at short notice and money raised easily. The market for cattle is very liquid, thereby making it very easy to dispose them off and raise money in case of any emergency.
Cattle is therefore a good investment, not so much for generating regular income, but as a fungible store of value for the farmer. It is at best only a supplementary economic activity for poor households. But do Government poverty alleviation policies provide cattle as a source of income or as an insurance against calamities and misfortunes.
In this context, an interesting area of study could be that relating to the economics of Government's poverty alleviation programs. A detailed opportunity cost analysis of cattle rearing as an economic activity could throw up interesting conclusions. It will also quantify the aforementioned observations regarding cattle rearing as an income generating activity.
It has been variously estimated that about one-half a man-day is spent in looking after cattle. This translates into Rs 35 per day, at a minimum wage of Rs 70, or Rs 1050 per month. But even the most optimistic income forecasts are Rs 900 for cow and Rs 650 for buffalo. We therefore appear to have an economic activity with a higher opportunity cost than its returns!
Let me give you the economics of animal husbandry. We will calculate the monthly returns from a cow and a buffalo, assuming the regular Government of India's NABARD norms. The cost of a cow yielding an average 10 litres of milk or a buffalo giving an average of 8 litres is about Rs 22000. These animals require good quality green fodder and feed concentrate to maintain their high milk yields. The average monthly expenditure on a cow is about Rs 1200, whereas the income is about Rs 2750, asssuming 25 days yielding milk fetching Rs 11 for a litre. This translates into a net monthly income of Rs 1550, if the farmer purchased the cow with his own money. Now this cow is purchased by a subsidy and soft loan from a bank, which would require a monthly repayment of about Rs 700 per month, over 3 years. The net return for the farmer is now only Rs 900 per month or Rs 10,800 annually.
If we replace the cow with buffalo, the figures look even more depressing. The monthly expenditure will be about Rs 1350, and the loan repayment Rs 650. Now the buffalo requires more care, and will give milk on an average for only 20 days, though its milk fetches atleast Rs 16 per litre due to the high fat content. This amounts to a monthly income of Rs 2650 from the milk sales. The net profit now falls to just Rs 650 per month or Rs 7800 every year.
Further, there are considerable uncertainties associated with cattle rearing. In most rural areas, during summers there is severe shortage of water and green fodder, which adversely affects the milk yield. In reality, the milk yield is much less than 10 litres and 8 litres, which means the incomes are proportionately lower. The farmer and his family spends considerable time and effort, sourcing green fodder and tending to the the cattle.
It has also been found from many studies that high cattle ownership coincides with lower school enrollment ratios. Cattle rearing is a low skill, but labor intensive activity. Therefore parents find it convenient to let their children take care of the cattle rearing task, while they can concentrate on their regular livelihoods. This dis-incentivizes parents from sending their children to schools.
However, cattle ownership has another more important dimension. A cow or a buffalo is a good storage of value. The cattle can be disposed off at short notice and money raised easily. The market for cattle is very liquid, thereby making it very easy to dispose them off and raise money in case of any emergency.
Cattle is therefore a good investment, not so much for generating regular income, but as a fungible store of value for the farmer. It is at best only a supplementary economic activity for poor households. But do Government poverty alleviation policies provide cattle as a source of income or as an insurance against calamities and misfortunes.
In this context, an interesting area of study could be that relating to the economics of Government's poverty alleviation programs. A detailed opportunity cost analysis of cattle rearing as an economic activity could throw up interesting conclusions. It will also quantify the aforementioned observations regarding cattle rearing as an income generating activity.
It has been variously estimated that about one-half a man-day is spent in looking after cattle. This translates into Rs 35 per day, at a minimum wage of Rs 70, or Rs 1050 per month. But even the most optimistic income forecasts are Rs 900 for cow and Rs 650 for buffalo. We therefore appear to have an economic activity with a higher opportunity cost than its returns!
Tuesday, September 25, 2007
Solid Waste Disposal
It is not a hyperbole to suggest that if we could somehow incentivize people themselves to collect litter and deposit them at designated places, we would have achieved a great feat of civic and social engineering.
Nobody will dispute the fact that solid waste disposal is one of the major challenges facing cities across the globe. Litterring is a major area of concern in every city, and all attempts at regulatory control through fines and legal deterrents, have not succeeded to the desired extent. So it is time to try out alternative approaches.
One of the main problems associated with the solid waste management chain, relates to difficulty in segregation of bio-degradable and non-degradable materials. Of all the non-degradable waste, the major problems are posed by plastic and other non-degradable packaging materials. The problems include those relating to environmental pollution and public health and sanitation, and are called negative externalities. The sellers and buyers of such packaged goods do not incur their share of the negative externalities imposed by their actions.
As has already been discussed in detail in previous posts, negative externalities impose disproportionately high social costs, while benefitting the agent causing it. In the absence of appropriate incentive structure, such externalities will tend to be over-supplied by the market. It is therefore important that the external costs inflicted on the society and the environment by the actions of the agent, are internalized.
It is important that the environmental and other social costs imposed by the use of plastic and other packaging materials are costed into the selling price. One way to do this is to charge the disposal cost on to the sale price of the product. While this would generate additional revenues to address the issue of disposal, it would still leave the main problem of actual segregation unresolved.
There is another way to address the problem. The external cost can be added to the sale price as a refundable deposit, which can then be given back when the buyer returns the packaging material. It can be arranged for the packaging material to be returned either at the same shop or any pre-designated shop. In fact, left to its own devices, a whole new market in collecting such packaging materials will develop, and we could have exclusive shops for procuring these waste materials. The additional cost collected as the refundable deposit, can be used to pay off the shops buying off these waste. The solid waste so collected can be either disposed off scientifically or recycled for further use. In due course of time, as the market matures, even the cost of disposing off the packaged material will be determined by the market.
This arrangement is a more sustainable attempt at segregation of non-degradable materials, than commonly adopted efforts like organizing rag pickers associations. It is likely to be more effective than even motivating housewives to segregate garbage at source. It is more likely to succeed because the incentive structure is compatible with the objective. The additional, refundable deposit incentivizes the buyers to collect and return the used packaging material.
Such an arrangement could throw up a market solution to the problem of solid waste disposal. To start with, this arrangement can be tried out for tetra packs, plastic and other bottles, and other similar packaging materials. It can later be extended to polythene bags and the more common packaging materials.
Nobody will dispute the fact that solid waste disposal is one of the major challenges facing cities across the globe. Litterring is a major area of concern in every city, and all attempts at regulatory control through fines and legal deterrents, have not succeeded to the desired extent. So it is time to try out alternative approaches.
One of the main problems associated with the solid waste management chain, relates to difficulty in segregation of bio-degradable and non-degradable materials. Of all the non-degradable waste, the major problems are posed by plastic and other non-degradable packaging materials. The problems include those relating to environmental pollution and public health and sanitation, and are called negative externalities. The sellers and buyers of such packaged goods do not incur their share of the negative externalities imposed by their actions.
As has already been discussed in detail in previous posts, negative externalities impose disproportionately high social costs, while benefitting the agent causing it. In the absence of appropriate incentive structure, such externalities will tend to be over-supplied by the market. It is therefore important that the external costs inflicted on the society and the environment by the actions of the agent, are internalized.
It is important that the environmental and other social costs imposed by the use of plastic and other packaging materials are costed into the selling price. One way to do this is to charge the disposal cost on to the sale price of the product. While this would generate additional revenues to address the issue of disposal, it would still leave the main problem of actual segregation unresolved.
There is another way to address the problem. The external cost can be added to the sale price as a refundable deposit, which can then be given back when the buyer returns the packaging material. It can be arranged for the packaging material to be returned either at the same shop or any pre-designated shop. In fact, left to its own devices, a whole new market in collecting such packaging materials will develop, and we could have exclusive shops for procuring these waste materials. The additional cost collected as the refundable deposit, can be used to pay off the shops buying off these waste. The solid waste so collected can be either disposed off scientifically or recycled for further use. In due course of time, as the market matures, even the cost of disposing off the packaged material will be determined by the market.
This arrangement is a more sustainable attempt at segregation of non-degradable materials, than commonly adopted efforts like organizing rag pickers associations. It is likely to be more effective than even motivating housewives to segregate garbage at source. It is more likely to succeed because the incentive structure is compatible with the objective. The additional, refundable deposit incentivizes the buyers to collect and return the used packaging material.
Such an arrangement could throw up a market solution to the problem of solid waste disposal. To start with, this arrangement can be tried out for tetra packs, plastic and other bottles, and other similar packaging materials. It can later be extended to polythene bags and the more common packaging materials.
Sunday, September 23, 2007
Elasticities of corruption
Regulation can have remarkably interesting results. Prof Greg Mankiw describes the consequences of a policy of crackdown on drugs supply, and how such a policy interacts with a simultaneous de-addiction programme.
Stricter drugs control measures include intensive crackdowns and enforcement measures, all of which reduces the available drugs supply in the market. This reduced supply however does not go along with any reduction in demand, as the number of drug users and their requirements remain the same. In other words, the demand for drugs is inelastic. As we learn from Eco 101, this is a recipe for immediate increase in the price of drugs. The drug users, most affected by the increase in price are those not well-off and are likely to be already involved in drugs related crime and violence. The price rise only imperils their situation, and worsens drugs related crime and violence. The chain of events goes something like this - greater the success in enforcement, lower the supply, greater the price rise, increase in drugs related crime and violence!
So Prof Mankiw, suggests that such policies cannot succeed without commensurate demand side management policies. One example of such policies include more active and visible counselling and de-addiction programmes. This would wean away existing drug users and thereby reduce demand, whose effects would offset the increase in price due to reduced supply. More successful the de-addiction program, greater the reduction in demand, and consequent fall in prices, and therefore drugs related crime.
Now replace the drugs supply economy with the corruption economy. Assume a very strict and honest officer takes charge of a Government office dealing directly with delivery of public services. He cracks down immediately on corrupt practices, and supsends a number of officials indulging in corruption. These supply side efforts, cannot hide the fact the demand for such services remains unabated. People still want to access services by jumping the que, push the limits of law and get services which they may not be eligible for. In other words, the elasticity of demand for accessing these civic services through the not so acceptable means, is very low. This naturally results in the price or rent for such services going up. Now the more versatile and entrepreneurial among officials, who manage to offer the services despite the stronger vigilance, have a bonanza. (Again Eco 101, higher the risk, greater the returns!) In fact, the increased vigilance is a godsend for them, as it increases the prices and drives out the less enterprising participants and makes the market less competitive.
Now if the corruption clampdown were accompanied by efforts which take into account the demand for such services, it would be much more sustainable and successful. One way to reduce the demand for jumping the que, would be by way of taking into account the differential willingness to pay and wants/needs of citizens and institutionalizing this. Something similar to price discrimination can be adopted to capture such customers and bring these transactions into the open. Tatkal schemes for delivery of certain services, privileged service access facility etc are examples of this. Computerization of process management, can help eliminate and easily detect procedural irregularities. Limiting interface channels can substantially bring down the opportunites for rent-seeking, besides reducing transaction costs for both the Government and the citizens. Single window clearances are excellent examples of these.
Most often policy makers get carried away by the easy appeal of regulatory policies that ultimately end up doing more harm than good. Such regulatory policies are easier to implement, more populist, and appear the most obvious attempts at tackling the issue. The more painstaking, process re-engineering efforts are difficult to implement and counselling cum awareness creation efforts, are forgotten or ignored. It may be a good idea to have a case study on this disucussed at the training programs for policy makers.
Stricter drugs control measures include intensive crackdowns and enforcement measures, all of which reduces the available drugs supply in the market. This reduced supply however does not go along with any reduction in demand, as the number of drug users and their requirements remain the same. In other words, the demand for drugs is inelastic. As we learn from Eco 101, this is a recipe for immediate increase in the price of drugs. The drug users, most affected by the increase in price are those not well-off and are likely to be already involved in drugs related crime and violence. The price rise only imperils their situation, and worsens drugs related crime and violence. The chain of events goes something like this - greater the success in enforcement, lower the supply, greater the price rise, increase in drugs related crime and violence!
So Prof Mankiw, suggests that such policies cannot succeed without commensurate demand side management policies. One example of such policies include more active and visible counselling and de-addiction programmes. This would wean away existing drug users and thereby reduce demand, whose effects would offset the increase in price due to reduced supply. More successful the de-addiction program, greater the reduction in demand, and consequent fall in prices, and therefore drugs related crime.
Now replace the drugs supply economy with the corruption economy. Assume a very strict and honest officer takes charge of a Government office dealing directly with delivery of public services. He cracks down immediately on corrupt practices, and supsends a number of officials indulging in corruption. These supply side efforts, cannot hide the fact the demand for such services remains unabated. People still want to access services by jumping the que, push the limits of law and get services which they may not be eligible for. In other words, the elasticity of demand for accessing these civic services through the not so acceptable means, is very low. This naturally results in the price or rent for such services going up. Now the more versatile and entrepreneurial among officials, who manage to offer the services despite the stronger vigilance, have a bonanza. (Again Eco 101, higher the risk, greater the returns!) In fact, the increased vigilance is a godsend for them, as it increases the prices and drives out the less enterprising participants and makes the market less competitive.
Now if the corruption clampdown were accompanied by efforts which take into account the demand for such services, it would be much more sustainable and successful. One way to reduce the demand for jumping the que, would be by way of taking into account the differential willingness to pay and wants/needs of citizens and institutionalizing this. Something similar to price discrimination can be adopted to capture such customers and bring these transactions into the open. Tatkal schemes for delivery of certain services, privileged service access facility etc are examples of this. Computerization of process management, can help eliminate and easily detect procedural irregularities. Limiting interface channels can substantially bring down the opportunites for rent-seeking, besides reducing transaction costs for both the Government and the citizens. Single window clearances are excellent examples of these.
Most often policy makers get carried away by the easy appeal of regulatory policies that ultimately end up doing more harm than good. Such regulatory policies are easier to implement, more populist, and appear the most obvious attempts at tackling the issue. The more painstaking, process re-engineering efforts are difficult to implement and counselling cum awareness creation efforts, are forgotten or ignored. It may be a good idea to have a case study on this disucussed at the training programs for policy makers.
Friday, September 21, 2007
Rational Expectations and corruption
There are numerous supply-side explanations of corruption, but very little analysis of the demand-side dynamics. However, it is widely acknowledged that our social ills get reflected in the decision making processes and service delivery channels of the Government.
We can take the example of a service delivered by a Municipal Corporation, say application for building licence. There is a general schedule of time frame for approvals of different categories of building applications. For simplicity, let us assume that a newly recruited clerk and Building Inspector (BI) are posted for dealing with such applications, and also that the applications can be approved by the BI.
Let also assume that the first and the second applicants comes and pays only the fixed application fees, and duly get their applications approved. Now comes the third applicant, who is conversant with Government delivery channels and the potential for obstacles and also in a need to get the application approved at the earliest. He offers a small speed money of Rs 1000 to expedite the approval. The newly recruited clerk and BI, if not already aware, have a first hand experience of their remuneration value. Then comes another applicant, with much greater willingness to pay, who pays Rs 5000 to get the approval done.
Now, assume the fifth applicant, a more naive and principled citizen, comes and pays just the schedule fees, thereby evoking the first signs of indignation and rensentment in the new staff. After making him run around a few times through multiple visits, the plan is cleared. Then comes another applicant without the willingness to fray the rent. By this time, our new recruits are more hardened and have resolved not to clear the plan without extracting atleast some rent. The process goes on. Over a period of time, an equilibrium is reached and a standard rental rate becomes formalized for each category of building application approval. The aforementioned story is a real chronology of events, albeit simplified, which came to light in the Town Planning section of the VMC.
Economists talk of the Theory of Adaptive Expectations, which claims that agents' expectations of the future value of an economic variable are based on past values. In repsonse to its flaws, Robert Lucas Jr developed the Theory of Rational Expectations, which postulates that agents take into account the full information available and form expectations of a future event or the future value of an economic varaible.
Taking cue from these theories, one can safely presume that both the applicants and the staff form adaptive or rational expectations about the processes and transactions in applying for a building licence approval and also the rental value of these transactions. Any over-indulgent behaviour by an applicant quickly sets in motion a chain of adaptive expectations that creates problems for the subsequent applicants. The applicants also form expectations about the inevitability of such speed payments and the rate for such transactions. The demand side dynamics therefore contributes substantially to the creation and the sustenance of the corruption economy.
We can take the example of a service delivered by a Municipal Corporation, say application for building licence. There is a general schedule of time frame for approvals of different categories of building applications. For simplicity, let us assume that a newly recruited clerk and Building Inspector (BI) are posted for dealing with such applications, and also that the applications can be approved by the BI.
Let also assume that the first and the second applicants comes and pays only the fixed application fees, and duly get their applications approved. Now comes the third applicant, who is conversant with Government delivery channels and the potential for obstacles and also in a need to get the application approved at the earliest. He offers a small speed money of Rs 1000 to expedite the approval. The newly recruited clerk and BI, if not already aware, have a first hand experience of their remuneration value. Then comes another applicant, with much greater willingness to pay, who pays Rs 5000 to get the approval done.
Now, assume the fifth applicant, a more naive and principled citizen, comes and pays just the schedule fees, thereby evoking the first signs of indignation and rensentment in the new staff. After making him run around a few times through multiple visits, the plan is cleared. Then comes another applicant without the willingness to fray the rent. By this time, our new recruits are more hardened and have resolved not to clear the plan without extracting atleast some rent. The process goes on. Over a period of time, an equilibrium is reached and a standard rental rate becomes formalized for each category of building application approval. The aforementioned story is a real chronology of events, albeit simplified, which came to light in the Town Planning section of the VMC.
Economists talk of the Theory of Adaptive Expectations, which claims that agents' expectations of the future value of an economic variable are based on past values. In repsonse to its flaws, Robert Lucas Jr developed the Theory of Rational Expectations, which postulates that agents take into account the full information available and form expectations of a future event or the future value of an economic varaible.
Taking cue from these theories, one can safely presume that both the applicants and the staff form adaptive or rational expectations about the processes and transactions in applying for a building licence approval and also the rental value of these transactions. Any over-indulgent behaviour by an applicant quickly sets in motion a chain of adaptive expectations that creates problems for the subsequent applicants. The applicants also form expectations about the inevitability of such speed payments and the rate for such transactions. The demand side dynamics therefore contributes substantially to the creation and the sustenance of the corruption economy.
Wednesday, September 19, 2007
Central Banks and market intervention
The troubles of the mortgage lending bank, Northern Rock, has been rocking the Labour Government in England and financial markets across the world. As the run on the bank gathered pace, the Chancellor of the Exchequer, Alistair Darling, stepped in to guarantee the bank's customers their deposits worth over $50 bn, thereby effectively nationalizing the Bank. This is only the latest in a series of turbulences ravaging the global financial markets, sparked off by the sub-prime mortgage lending defaults in the US.
Nobody knows the exact extent and scope of this crisis, and when we are likley to get out of it. There is the usual debate about whether the Central Banks, notably the US Federal Reserve, should intervene and stabilise the markets. The Governor of the Bank of England, Mr Mervyn King, has come out openly arguing against any intervention by way of lowering interest rates since that would create a "moral hazard", by incentivizing reckless and greedy lenders. There is an excellent backgroud piece on this debate by Kenneth Rogoff in the Guardian, The Fed v the financiers.
The past two decades have seen too many instances of irresponsible lending by financial institutions, and every time a crisis occurs they are bailed out by Government with tax payer's money. The sub-prime mortgage crisis is only the latest in a long series of such reckless lending inspired financial fiascoes like the Savings and Loans scandal, the Latin American Tequila crisis, the collapse of LTCM, the dot com bubbles etc. The opponents of Central Bank intervention argue that such crisis will continue to occur, if suitably strong message is not sent across to ally all such "moral hazard" generating expectations. Further, such a shakeout is necessary to eliminate all the dubious investments made in the recent past. The proponents of bailouts, in turn argue that unless the crisis is contained before it spreads, it could paralyse the entire financial markets, with far reaching implications for the global economy itself.
Central Banking is, even at the best of times, a delicate balancing act. There are no clear algorithmic prescriptions that can be taken off the shelf and applied to set situations. Personal judgement and experience play a critical role in guiding us in choosing a particular alternative from a bouquet of options. Given the complex context, in the true spirit of scepticism, we need to ask all the possible questions, before venturing afar with the policy prescriptions.
Even if we accept the arguement of the proponents of intervention by Central Banks, it still leaves us with the question of how to recognize that a financial crisis has the potential to threaten the global economy? More importantly, can we confidently conclude as to which events are likely to destabilize the global financial markets and which not? Where do we draw the line between moral hazard and practical concerns of economic stability and growth? How do we recognize the symptoms of the arrival of a tipping point when the crisis threatens to spread out of control and drag the economy down? Should we leave the decision making on such an important issue to the discretion of a Central bank, or to the cold logic of certain financial and macroeconomic parameters and indices? If the later, what are those parameters which should be indicators of an impending economic crisis, that should trigger an intervention by the Central Banks?
The question is not just whether Central Banks should intervene or not. But, are Central Banks the right agencies to intervene in such situations? If they are and they ought to intervene, then under what circumstances? If not, should we leave the financial markets to find its own market solution? Is monetary policy the only instrument of such intervention? Or else, what other instruments of macroeconomic policy can be used to stablize the markets?
If we argue for Central Banks interventions, does it not presume that they are better positioned to understand the trends and consequences of movements in the global equity markets? Do Central Banks have any extra wisdom that helps them understand the global financial markets better than even the best of fund managers and investors, assisted as they are by rocket scientists and even Nobel laureates, crunching numbers on super computers?
Answers to these questions are also dependent on the objectives assigned to Central banks in each country. Is price stability and hence inflation targetting, to the exclusion of even short or even medium-term economic growth concerns, the primary objective of Central Banks? Or does even short and medium-term economic growth concerns take precedence?
There is an analysis of the role of Central Banks by Gary Becker, Should Central Banks Intervene During This Financial Crisis? and a description of the anatomy of the sub-prime bubble by Richard Posner, Against Bailouts, in two articles in their joint blog.
Nobody knows the exact extent and scope of this crisis, and when we are likley to get out of it. There is the usual debate about whether the Central Banks, notably the US Federal Reserve, should intervene and stabilise the markets. The Governor of the Bank of England, Mr Mervyn King, has come out openly arguing against any intervention by way of lowering interest rates since that would create a "moral hazard", by incentivizing reckless and greedy lenders. There is an excellent backgroud piece on this debate by Kenneth Rogoff in the Guardian, The Fed v the financiers.
The past two decades have seen too many instances of irresponsible lending by financial institutions, and every time a crisis occurs they are bailed out by Government with tax payer's money. The sub-prime mortgage crisis is only the latest in a long series of such reckless lending inspired financial fiascoes like the Savings and Loans scandal, the Latin American Tequila crisis, the collapse of LTCM, the dot com bubbles etc. The opponents of Central Bank intervention argue that such crisis will continue to occur, if suitably strong message is not sent across to ally all such "moral hazard" generating expectations. Further, such a shakeout is necessary to eliminate all the dubious investments made in the recent past. The proponents of bailouts, in turn argue that unless the crisis is contained before it spreads, it could paralyse the entire financial markets, with far reaching implications for the global economy itself.
Central Banking is, even at the best of times, a delicate balancing act. There are no clear algorithmic prescriptions that can be taken off the shelf and applied to set situations. Personal judgement and experience play a critical role in guiding us in choosing a particular alternative from a bouquet of options. Given the complex context, in the true spirit of scepticism, we need to ask all the possible questions, before venturing afar with the policy prescriptions.
Even if we accept the arguement of the proponents of intervention by Central Banks, it still leaves us with the question of how to recognize that a financial crisis has the potential to threaten the global economy? More importantly, can we confidently conclude as to which events are likely to destabilize the global financial markets and which not? Where do we draw the line between moral hazard and practical concerns of economic stability and growth? How do we recognize the symptoms of the arrival of a tipping point when the crisis threatens to spread out of control and drag the economy down? Should we leave the decision making on such an important issue to the discretion of a Central bank, or to the cold logic of certain financial and macroeconomic parameters and indices? If the later, what are those parameters which should be indicators of an impending economic crisis, that should trigger an intervention by the Central Banks?
The question is not just whether Central Banks should intervene or not. But, are Central Banks the right agencies to intervene in such situations? If they are and they ought to intervene, then under what circumstances? If not, should we leave the financial markets to find its own market solution? Is monetary policy the only instrument of such intervention? Or else, what other instruments of macroeconomic policy can be used to stablize the markets?
If we argue for Central Banks interventions, does it not presume that they are better positioned to understand the trends and consequences of movements in the global equity markets? Do Central Banks have any extra wisdom that helps them understand the global financial markets better than even the best of fund managers and investors, assisted as they are by rocket scientists and even Nobel laureates, crunching numbers on super computers?
Answers to these questions are also dependent on the objectives assigned to Central banks in each country. Is price stability and hence inflation targetting, to the exclusion of even short or even medium-term economic growth concerns, the primary objective of Central Banks? Or does even short and medium-term economic growth concerns take precedence?
There is an analysis of the role of Central Banks by Gary Becker, Should Central Banks Intervene During This Financial Crisis? and a description of the anatomy of the sub-prime bubble by Richard Posner, Against Bailouts, in two articles in their joint blog.
Sunday, September 16, 2007
Trading in antiquities
There is an article by Daniel Gross in the Slate, Rent-A-Treasure, which quotes an idea put forward by Harvard Professor Micheal Kremer about renting of antiques.
Prof Kremer argues that since a large number of priceless antiquities are found in the poor, developing countries, who cannot afford to excavate, research and protect them properly, it may be appropriate to rent them out to the major museums of the world for a rental fee and a fixed period. Besides ensuring the proper maintanence and upkeep of these valuable treasures, it will also fetch significant sums for these countries. Such an arrangement would be the equivalent of outsourcing the maintenance of these antiquarts to professionally competent agencies!
Prof Kremer argues that since a large number of priceless antiquities are found in the poor, developing countries, who cannot afford to excavate, research and protect them properly, it may be appropriate to rent them out to the major museums of the world for a rental fee and a fixed period. Besides ensuring the proper maintanence and upkeep of these valuable treasures, it will also fetch significant sums for these countries. Such an arrangement would be the equivalent of outsourcing the maintenance of these antiquarts to professionally competent agencies!
Alternate livelihoods of the urban poor
It is commonplace in urban slums to find women squatting with small stoves, cooking dosas and idlis on the road and street margins. By a conservative estimate, there are well over 5000 such small eating establishments in Vijayawada. Such establishments exist on street and road margins, and require only the minimum investment of a gas stove and cooking utensils. Being on the road margins, there is no place for eating and the buyers are expected to take home the food and eat. This makes it one of the largest single economic activities in the City. However, this entire livelihood system is in the unorganised sector.
On an average, a street margin vendor earns Rs 150-200 every day, for 3-4 hours of work. After the breakfast, by about 10.00 AM, these women pack off and get to their regular work. This activity therefore becomes a very lucrative alternate source of income for the family.
Why do urban slum households patronize such eateries and not cook breakfast at home? The opportunity cost of cooking at home is much higher than the opportunity cost of buying from such eating establishments. Therefore a considerable proportion of slum dwellers do not cook any breakfast at home and rely on such streetside eateries. There are several reasons why the opportunity cost associated with cooking at homes is very high.
Typically houses in urban slums are very small and do not have full fledged kitchens. Most often there is a single room which has a makeshift kitchen in one corner. Most slum dwellers have to get up early and go for work, and therefore have limited time available for cooking the morning breakfast. Further, South Indian breakfasts are inherently difficult in preparation and takes inordinately long preparation time. Early morning hours are valuable for slum residents for a number of reasons. Apart from their personal tasks, the women have to catch and store water (which is typically released for a couple of hours in the morning), wash vessels and clothes, get children ready for school, and also prepare lunch for the entire family (typically both husband and wife work during the daytime).
Further, a majority of slum households have atleast one tenant. The houseowner rents out a portion, generally a room, to supplement his income. (They get around Rs 500-1000 every month from this). The tenants generally do not have the space for establishing a kitchen and invariably rely on these eateries for their breakfast. These tenants are a substantial customer base for these food vendors.
Therefore, for an urban slum dweller, the opportunity cost of spending valuable morning time in preparing breakfast is huge. The costs include not being able to either catch water or clean their clothes and vessels or the family having to go without lunch. Faced with such steep costs, the slum dweller decides to make the choice of buying breakfast from street side eateries.
On an average, a street margin vendor earns Rs 150-200 every day, for 3-4 hours of work. After the breakfast, by about 10.00 AM, these women pack off and get to their regular work. This activity therefore becomes a very lucrative alternate source of income for the family.
Why do urban slum households patronize such eateries and not cook breakfast at home? The opportunity cost of cooking at home is much higher than the opportunity cost of buying from such eating establishments. Therefore a considerable proportion of slum dwellers do not cook any breakfast at home and rely on such streetside eateries. There are several reasons why the opportunity cost associated with cooking at homes is very high.
Typically houses in urban slums are very small and do not have full fledged kitchens. Most often there is a single room which has a makeshift kitchen in one corner. Most slum dwellers have to get up early and go for work, and therefore have limited time available for cooking the morning breakfast. Further, South Indian breakfasts are inherently difficult in preparation and takes inordinately long preparation time. Early morning hours are valuable for slum residents for a number of reasons. Apart from their personal tasks, the women have to catch and store water (which is typically released for a couple of hours in the morning), wash vessels and clothes, get children ready for school, and also prepare lunch for the entire family (typically both husband and wife work during the daytime).
Further, a majority of slum households have atleast one tenant. The houseowner rents out a portion, generally a room, to supplement his income. (They get around Rs 500-1000 every month from this). The tenants generally do not have the space for establishing a kitchen and invariably rely on these eateries for their breakfast. These tenants are a substantial customer base for these food vendors.
Therefore, for an urban slum dweller, the opportunity cost of spending valuable morning time in preparing breakfast is huge. The costs include not being able to either catch water or clean their clothes and vessels or the family having to go without lunch. Faced with such steep costs, the slum dweller decides to make the choice of buying breakfast from street side eateries.
Friday, September 14, 2007
Energy savings through lighting technologies
For those Greens and those interested in reducing their energy budgets, there is an interesting article by Ashley Seager, Illuminating Ideas.
Seager claims to have changed all his lights to energy saving fixtures, and thereby reduced his lighting load from 3000 Watts to 650 Watts, or a saving of 2350 W. If 1000 houses could do this, we could reduce our load by 2.35 MW! We can make a very serious dent in our crippling power deficits by such small and simple interventions.
It is also an ideal stage for implementing some economic concepts. Apart from the high energy bills, the regular energy guzzling bulbs generate negative externalities, by contributing to our power shortages. In contrast, the energy saving bulbs generate positive externalities by not only reducing the individual power bills, but also by bridging our power shortages.
The resultant market failure calls for incentivizing the sellers of such energy saving bulbs and disincentivizing the sellers of the normal, energy guzzling bulbs. This can be done by taxation and through regulations. The energy saving bulb manufacturers can be given tax incentives, and the energy guzzling bulbs can be taxed heavily as a disincentive.
It can also be made mandatory for all Government Institutions and buildings with plinth area beyond a certain extent to go for energy saving devices. The building regulations can be appropriately modified to bring in these conditions. There is already a precedent of mandatory requirement for installing solar heating systems for apartments and certain categories of establishments.
Seager claims to have changed all his lights to energy saving fixtures, and thereby reduced his lighting load from 3000 Watts to 650 Watts, or a saving of 2350 W. If 1000 houses could do this, we could reduce our load by 2.35 MW! We can make a very serious dent in our crippling power deficits by such small and simple interventions.
It is also an ideal stage for implementing some economic concepts. Apart from the high energy bills, the regular energy guzzling bulbs generate negative externalities, by contributing to our power shortages. In contrast, the energy saving bulbs generate positive externalities by not only reducing the individual power bills, but also by bridging our power shortages.
The resultant market failure calls for incentivizing the sellers of such energy saving bulbs and disincentivizing the sellers of the normal, energy guzzling bulbs. This can be done by taxation and through regulations. The energy saving bulb manufacturers can be given tax incentives, and the energy guzzling bulbs can be taxed heavily as a disincentive.
It can also be made mandatory for all Government Institutions and buildings with plinth area beyond a certain extent to go for energy saving devices. The building regulations can be appropriately modified to bring in these conditions. There is already a precedent of mandatory requirement for installing solar heating systems for apartments and certain categories of establishments.
Thursday, September 13, 2007
Free lunches in the software industry
Indian software industry is acclaimed as one of the major economic success stories of recent decades. The figures are impressive and there is surely considerable substance in the growth story. It has single-handendly lifted India to the league of a knowledge super power, and imparted a huge stimulus to the Indian economic growth engine. From being marginal a decade back, Indian software exports have surged to over $32 bn in 2006-07. But closer scrutiny reveals a few areas of concern, and they are being increasingly felt, and often with bitter consequences.
The recent strengthening of the rupee has generated much heartburn in the boardrooms of our software companies. There have been calls by all the major companies for the RBI to inervene in the foreign exchange markets to stabilize the rupee. The increasing rupee makes our exports, whose expenditures are mainly rupee denominated, costlier and thereby affects our export competitiveness. The dependence of our software companies on a weak rupee is substantial.
A recent study by First Global Securities Ltd on the Indian software industry throws up certain interesting conclusions. It brings out starkly the extent of dependence of software companies margins on a weak rupee. It shows that the 36% depreciation of the rupee in the past 11 years, has contributed atleast 40-67% to the margins of our software majors. It claims that the high profit margins of 19-27% are due to a "currency subsidy". The appreciating rupee becomes a challenge, especially since well over half the sales of the top companies (except TCS) are to the US market, leaving them with dollar denominated revenues and rupee expenditure.
The cheap labor costs or billing rates, by acting as a form of "wage subsidy", have been another major source of comparative advantage for our companies. Initially the labor costs were only a fraction of those in the developed markets, thereby contributing substantially to the profit margins of these firms. But with rapidly increasing wage rates, this advantage is fast diminishing. This wage inflation is eroding the fat profit margins and reducing our comparative advantage. In any case, the wage arbitrage which these companies took advantage of, arose due to the inherent economic inefficiencies and was bound to disappear.
Further, our software industry also benefitted by being active participants in the initial, high growth phase of the software industry. The growth rates can be very high and margins spectacular with any sector in its initial growth phase, as there exists numerous, easy to adapt opportunities for efficiency improvements at the margin. Consequently, our software firms have been doubling their revenues and profits every two to three years. But with greater competition and as the market matures, it is inevitable that the margins decline and growth rates fall to more reasonable levels. Globally, software industry is today much more competitive and efficient, and this reflects in the fast diminishing opportunities for higher profits.
It is one of the fundamental axioms of economic theory that there are no free lunches. There are costs, explicit or implicit, associated with any decision. Benefits or economic returns are always associated with costs. If the economy is not operating at the efficient frontier, it may so appear for some time atleast, that there are no costs associated with some decisions. The arbitrage opportunities presented by way of a weak rupee and low wages were free lunches. So too were the fat margins and growth opportunities available due to the initial growth phase of software sector. And as is the case with such free lunches, they cannot go on forever. As the economy becomes more competitive and efficient, these free lunches have to end.
The moral of the story is that as competition increases and the sector becomes more efficient, all free lunches in the software industry are going to end. Therefore our software companies should, instead of lobbying for keeping the rupee weak, be facing up to the reality of a competitive and efficient market. They should be on the constant look out for newer opportunities, exiting from low margin and low growth areas, and migrating to newer high growth, high margin areas.
They also need to seriously pursue developing the local software market. I am not sure about this, but it may not be off the mark to claim that there would not be too many Indian companies, among the top ten clients of each of our software majors. The story of our software industry is somewhat similar to the manufacturing sector in the East Asian economies. The local market for manufactured produce was small, and these countries relied on massive exports. As we have seen, there are limits to this type of growth.
Knowledge based industries are fertile workshops for Joseph Schumpeter's hypothesis of "creative destruction" at work. With rapidly evolving technolgies and work process innovations, software industry is especially vulnerable to this trend. Only the most adaptable and nimble firms can survive in this highly competitive environment. Therefore, instead of relying on free lunches, our software firms need to innovate or languish and perish!
Update 1
Another free lunch is the handsome tax holiday on Software Technology Parks, which extends till March 2009.
Update 2 (22/10/2010)
In this context, of relevance is the ongoing debate in India about letting the tax expemptions provided to IT companies located within the Software Technology Parks of India (STPI) expire at the end of fiscal 2010-11. The Government of India had provided a 10-year tax holiday to IT firms, which though was supposed to expire at the end of 2008-09, has been extended twice till March 2011 under pressure from the software industry who whine about competition from other "low-cost" countries.
The recent strengthening of the rupee has generated much heartburn in the boardrooms of our software companies. There have been calls by all the major companies for the RBI to inervene in the foreign exchange markets to stabilize the rupee. The increasing rupee makes our exports, whose expenditures are mainly rupee denominated, costlier and thereby affects our export competitiveness. The dependence of our software companies on a weak rupee is substantial.
A recent study by First Global Securities Ltd on the Indian software industry throws up certain interesting conclusions. It brings out starkly the extent of dependence of software companies margins on a weak rupee. It shows that the 36% depreciation of the rupee in the past 11 years, has contributed atleast 40-67% to the margins of our software majors. It claims that the high profit margins of 19-27% are due to a "currency subsidy". The appreciating rupee becomes a challenge, especially since well over half the sales of the top companies (except TCS) are to the US market, leaving them with dollar denominated revenues and rupee expenditure.
The cheap labor costs or billing rates, by acting as a form of "wage subsidy", have been another major source of comparative advantage for our companies. Initially the labor costs were only a fraction of those in the developed markets, thereby contributing substantially to the profit margins of these firms. But with rapidly increasing wage rates, this advantage is fast diminishing. This wage inflation is eroding the fat profit margins and reducing our comparative advantage. In any case, the wage arbitrage which these companies took advantage of, arose due to the inherent economic inefficiencies and was bound to disappear.
Further, our software industry also benefitted by being active participants in the initial, high growth phase of the software industry. The growth rates can be very high and margins spectacular with any sector in its initial growth phase, as there exists numerous, easy to adapt opportunities for efficiency improvements at the margin. Consequently, our software firms have been doubling their revenues and profits every two to three years. But with greater competition and as the market matures, it is inevitable that the margins decline and growth rates fall to more reasonable levels. Globally, software industry is today much more competitive and efficient, and this reflects in the fast diminishing opportunities for higher profits.
It is one of the fundamental axioms of economic theory that there are no free lunches. There are costs, explicit or implicit, associated with any decision. Benefits or economic returns are always associated with costs. If the economy is not operating at the efficient frontier, it may so appear for some time atleast, that there are no costs associated with some decisions. The arbitrage opportunities presented by way of a weak rupee and low wages were free lunches. So too were the fat margins and growth opportunities available due to the initial growth phase of software sector. And as is the case with such free lunches, they cannot go on forever. As the economy becomes more competitive and efficient, these free lunches have to end.
The moral of the story is that as competition increases and the sector becomes more efficient, all free lunches in the software industry are going to end. Therefore our software companies should, instead of lobbying for keeping the rupee weak, be facing up to the reality of a competitive and efficient market. They should be on the constant look out for newer opportunities, exiting from low margin and low growth areas, and migrating to newer high growth, high margin areas.
They also need to seriously pursue developing the local software market. I am not sure about this, but it may not be off the mark to claim that there would not be too many Indian companies, among the top ten clients of each of our software majors. The story of our software industry is somewhat similar to the manufacturing sector in the East Asian economies. The local market for manufactured produce was small, and these countries relied on massive exports. As we have seen, there are limits to this type of growth.
Knowledge based industries are fertile workshops for Joseph Schumpeter's hypothesis of "creative destruction" at work. With rapidly evolving technolgies and work process innovations, software industry is especially vulnerable to this trend. Only the most adaptable and nimble firms can survive in this highly competitive environment. Therefore, instead of relying on free lunches, our software firms need to innovate or languish and perish!
Update 1
Another free lunch is the handsome tax holiday on Software Technology Parks, which extends till March 2009.
Update 2 (22/10/2010)
In this context, of relevance is the ongoing debate in India about letting the tax expemptions provided to IT companies located within the Software Technology Parks of India (STPI) expire at the end of fiscal 2010-11. The Government of India had provided a 10-year tax holiday to IT firms, which though was supposed to expire at the end of 2008-09, has been extended twice till March 2011 under pressure from the software industry who whine about competition from other "low-cost" countries.
My Mint article on urban housing vouchers
"How to house the urban poor" has appeared as a Mint op-ed.
Tuesday, September 11, 2007
Lottery Bonds
In an article, Investing in the Poor, Prof Robert Shiller talks about the work done by Peter Tufano, a finance professor at Harvard Business School, who has been doing nonprofit work with the foundation he created, Doorways to Dreams, to help low-income people improve their financial prospects. He writes,
Such "price linked accounts" may have an important role to play in promoting long-term savings among the poor people. Instead of providing unsustainable direct assistance through revolving funds, interest subsidies and the like, the Government can attach lottery bonds to Self Help Group (SHG) accounts. This will encourage SHGs to save for the long-term, and not utilize all their savings for consumption and other short-term needs.
"According to Tufano, the fundamental problem in encouraging low-income people to save is that they need the money not just to manage their lives years in the future, when they retire, but also to deal with short-term crises. But if government programs designed to promote saving by low-income people don’t tie up their money for many years until retirement, they will often succumb to temptation and spend the money frivolously.
Tufano approaches the problem with real sympathy for these people, and a realistic idea about how to help them: premium savings bonds. In addition to normal interest payments, these bonds have an attached lottery – an enticement to keep the money in savings. Low-income people manifestly enjoy lotteries, and they will acquire the habit of looking forward to the lottery dates, which will deter them from cashing in their bonds. But if a real emergency arises, they can get their money.
In fact, lottery bonds have a long history. In 1694, the English government issued a 10% 16-year bond called “the Million Adventure,” which awarded prizes randomly each year to its holders. Likewise, Harold MacMillan’s government created a lottery bonds program – called premium bonds, or “saving with a thrill” – in the United Kingdom in 1956. The program was controversial at first: many viewed it as immoral, because of its connection with gambling. But the program has grown, and today premium bonds have a place in the saving portfolio of 23 million people, almost 40% of the UK population. Sweden, too, has such bonds, as do other countries."
Such "price linked accounts" may have an important role to play in promoting long-term savings among the poor people. Instead of providing unsustainable direct assistance through revolving funds, interest subsidies and the like, the Government can attach lottery bonds to Self Help Group (SHG) accounts. This will encourage SHGs to save for the long-term, and not utilize all their savings for consumption and other short-term needs.
Monday, September 10, 2007
Commodities Exchanges
That the farmers in the developing countries face serious deficiencies in availability of storage and marketing facilities is common knowledge. The storage and marketing infrastructure developed by Government agencies is severely deficient or even absent, in many villages.
In this context, one of the more interesting developments in global financial markets in the recent years, has been the emergence of a vibrant commodities trading market. A number of commodities exchanges have appeared as facilitating platforms for trade in commodities. These exchanges have led to the development of a network of storage and marketing logistics and the attendant infrastructure around them. In fact, it makes great economic sense to link up the existing logistics and infrastructure, both private and Government owned, to these exchanges.
A transaction in a commodities exchange works something like this. Mr. Farmer, growing green gram can sell a futures contract on his yet to be harvested (or even sowed) crop, and be guaranteed the price he will be paid when he delivers the produce; a Reliance Fresh retailer can buy the futures contract in green gram, and thereby protect himself from any possibility of a price rise, when the crop is delivered. This simultaneously hedges the producer, Mr Farmer, from price drops and the buyer, Relaince Fresh, from price rises.
The opportunities for forward linkages are numerous and some of them are potentially very profitable for farmers. The recent emergence of retail fruits, vegetable and grocery chains across the country has the potential for radically altering the commodities procurement landscape.
But unfortunately these developments and its advantages have benefited only a very few large farmers, as they trade mainly in commercial crops like coffee and tea. Foodgrains like paddy, wheat, millets, and pulses and even oil seeds are either not traded or form a very small proportion of the commodities traded. The small farmers, who stand to benefit the most by such interventions have therefore not benefitted to the desired extent, and most of them have been bypassed by these developments.
A typical commodities exchange could have all the interested farmers of the village enrolled as its members, through a subscription. The members can then put up their produce for trade, and let the exchange market identify the right kind of buyer and price. The exchange could be linked up to other exchanges, which will help the farmer access real time price and other information, and also a larger pool of buyers. The farmer will then be able to make informed decisions and also get the best price for his produce.
Further, with the vast potential of Information Technology and Communications, it is possible to obtain real time information about commodities from markets across the globe. Such seamlessly integrated exchanges, which includes among its members a large proportion of small farmers can, wash away arbitrage opportunities and bring greater returns to them.
In fact, instead of focussing solely on Minimum Support Price (MSP) and other direct market intervention support to farmers, the Food Corporation of India (FCI), the agency responsible for these interventions, should be paying more attention to commodities trading and exchanges. In fact, the FCI could emerge as a sort of regulator of all the private and public commodities exchanges across the country.
The Government should catalyse and initially support the setting up of commodities exchanges, which bring together the local sellers and local and outside buyers into a single transparent trading platform. Given the massive profit opportunities available in commodities trading - both retail and wholesale - the Government should actively seek to leverage private sector resources to set up storage and marketing facilties.
To start with, these exchanges can have very rigorous margin requirements and daily or atleast two day settlements. This will help avoid some of the common problems and pitfalls associated with financial markets. Quality and other commodity specific parameters have to be standardized with appropriate regulation, duly taking into account local requirements.
It is a win-win model for all stakeholders. The farmers have access to the latest market information, larger choice of buyers, and adequate storage facilities, all of which help get much better returns on their produce. The wholesale traders and retailers have an institutionalized arrangement which brings together the entire market into a single trading platform. This lowers their substantial transaction costs, helps source better quality commodities, and also ensures assured and regular supply of goods. By eliminating substantial transaction costs, hitherto captured by rent-seeking and parasitic middlemen, these exchanges could also contribute towards lowering the prices of agricultural produce for all of us.
In this context, one of the more interesting developments in global financial markets in the recent years, has been the emergence of a vibrant commodities trading market. A number of commodities exchanges have appeared as facilitating platforms for trade in commodities. These exchanges have led to the development of a network of storage and marketing logistics and the attendant infrastructure around them. In fact, it makes great economic sense to link up the existing logistics and infrastructure, both private and Government owned, to these exchanges.
A transaction in a commodities exchange works something like this. Mr. Farmer, growing green gram can sell a futures contract on his yet to be harvested (or even sowed) crop, and be guaranteed the price he will be paid when he delivers the produce; a Reliance Fresh retailer can buy the futures contract in green gram, and thereby protect himself from any possibility of a price rise, when the crop is delivered. This simultaneously hedges the producer, Mr Farmer, from price drops and the buyer, Relaince Fresh, from price rises.
The opportunities for forward linkages are numerous and some of them are potentially very profitable for farmers. The recent emergence of retail fruits, vegetable and grocery chains across the country has the potential for radically altering the commodities procurement landscape.
But unfortunately these developments and its advantages have benefited only a very few large farmers, as they trade mainly in commercial crops like coffee and tea. Foodgrains like paddy, wheat, millets, and pulses and even oil seeds are either not traded or form a very small proportion of the commodities traded. The small farmers, who stand to benefit the most by such interventions have therefore not benefitted to the desired extent, and most of them have been bypassed by these developments.
A typical commodities exchange could have all the interested farmers of the village enrolled as its members, through a subscription. The members can then put up their produce for trade, and let the exchange market identify the right kind of buyer and price. The exchange could be linked up to other exchanges, which will help the farmer access real time price and other information, and also a larger pool of buyers. The farmer will then be able to make informed decisions and also get the best price for his produce.
Further, with the vast potential of Information Technology and Communications, it is possible to obtain real time information about commodities from markets across the globe. Such seamlessly integrated exchanges, which includes among its members a large proportion of small farmers can, wash away arbitrage opportunities and bring greater returns to them.
In fact, instead of focussing solely on Minimum Support Price (MSP) and other direct market intervention support to farmers, the Food Corporation of India (FCI), the agency responsible for these interventions, should be paying more attention to commodities trading and exchanges. In fact, the FCI could emerge as a sort of regulator of all the private and public commodities exchanges across the country.
The Government should catalyse and initially support the setting up of commodities exchanges, which bring together the local sellers and local and outside buyers into a single transparent trading platform. Given the massive profit opportunities available in commodities trading - both retail and wholesale - the Government should actively seek to leverage private sector resources to set up storage and marketing facilties.
To start with, these exchanges can have very rigorous margin requirements and daily or atleast two day settlements. This will help avoid some of the common problems and pitfalls associated with financial markets. Quality and other commodity specific parameters have to be standardized with appropriate regulation, duly taking into account local requirements.
It is a win-win model for all stakeholders. The farmers have access to the latest market information, larger choice of buyers, and adequate storage facilities, all of which help get much better returns on their produce. The wholesale traders and retailers have an institutionalized arrangement which brings together the entire market into a single trading platform. This lowers their substantial transaction costs, helps source better quality commodities, and also ensures assured and regular supply of goods. By eliminating substantial transaction costs, hitherto captured by rent-seeking and parasitic middlemen, these exchanges could also contribute towards lowering the prices of agricultural produce for all of us.
Friday, September 7, 2007
Exit Tax on IIT and IIM graduates
The Parliamentary Standing Committee on HRD, recently submitted a report recommending an "exit tax" on those students passing out from the premier government institutions like the IITs and IIMs, who leave the country after graduation. The rationale behind the exit tax is that, the State subsidises an IIT and IIM student to an extent of Rs 1.5 lakh and Rs 3.5 lakh each year respectively, and only a small portion of this is recovered as fees. It is hoped that an exit tax will stem the brain drain and also recover atleast the expenditure incurred on the student.
There are evidently two objectives - deterring brain drain and cost recovery/revenue generation. Before we proceed any further, we need to examine whether these two objectives are desirable or not? Assuming the objectives are desirable, is the exit tax the best solution? If not, are there better solutions to achieving these objectives?
While revenue generation and cost recovery is a no brainer, I am not convinced of the need to deter brain drain. Brian drain can arise from graduate students pursuing higher studies in foreign, mainly US, universities, and those getting recruited by MNCs to work outside the country. The brain drain that results from students pursuing higher studies abroad, also generates very useful positive externalities. It is undeniable that those who go abroad for higher studies amass susbtantial value addition, for which there limited opportunities available in India. These talented individuals, exposed as they are to the best practices and latest technologies, and equipped with world-class professional expertise, have contributed immensely to the spectacular growth of our software and knwoledge based industries.
Many of them, graduates of our premier professional institutes, have returned back to India to capitalize on their professional expertise, either as part of the large number of MNCs operating here in various sectors, or by themselves starting companies. Those who have not returned yet, play a significant role in influencing, in our favor, the investment and other strategic decisions of MNCs and even Governments across the globe. Many of these graduates occupy the highest echelons of the private (and even Government) sector bureaucracy. They also form a significant proportion of the scientific manpower pursuing cutting edge research across the globe. It is arguably true that their foreign education and exposure to opportunities, which are unavailable in India even now, have catapulted them into their present status.
The multiplier effect on the Indian economy due to them is arguably many times more than the expenditure incurred in training them. In purely business terms, if India were a company and these graduates its investment, then the Chief Financial Officer of India would have to be given a hefty bonus for generating such handsome Returns on Investment (RoI). It will be interesting if some study can attempt quantifying the IRR on investment in these graduates!
The arguement against the other category of brain drain, to the private sector, is fallacious. At first sight, those graduates who take jobs abroad may appear to be a loss to our economy. But a closer scrutiny reveals that the graduates from IITs and in particular IIMs, invariably join private MNCs, who have operations across the globe. The highly skilled professional manpower of these companies increasingly belong to a category of "global employees", who frequently navigate across the geographical boundaries of operation of the company.
The dilemma we face is simple. Do we retain our best talent in India as semi-finished human resources or permit them to utilize all the opportunity available to realize their full potential? I am inclined to believe in the latter. We need to acknowledge the reality of a global workforce, unconstrained by the physical limitations imposed by national boundaries.
The arguement about cost recovery and revenue generation through the exit tax is a red herring. Even assuming full cost recovery from all the graduates from these institutions, we are talking about just a few crores of rupees, while the costs are substantial. Any tax causes distortions in the incentive structure. The issue we need to consider is whether the benefits of an exit tax by way of additional revenues, outweigh the costs incurred by way of distortion in the incentive structure.
I am convinced that any attempt at effectively utilizing these local talent to our advantage, without compromising on the full potential for value addition, has to be incentive compatible. Without the appropriate incentive structure, any regulatory approach will lead to sub-optimal outcomes. Further, in an age of the "global employee", it may not even be appropriate to look at individual talent as the exclusive property of any country. Knowledge industries are not circumscribed by the physical limitations of national or company boundaries and thrive on the free movement of ideas and people across nations and companies. Since India prides itself as a knowledge superpower, it may be ironical for us to impose restrictions on the free movement of our human talent.
In any case, simplistic supply side fixes to such social and economic problems generally fail. They do not properly appreciate the complex demand side, incentive structure that drives issues like brain drain.
With points and counter-points flying in all directions, it is imperative that the debate be illuminated by more informed analysis of facts. I am surprised that there is no empirical study of the likely consequences of an exit tax or the positive externality generated by brain drain. We need to compare and study large enough samples of students who have gone abroad for higher studies, jobs, and those who have stayed at home.
It would help if we could have reliable data on the proportion of these graduates who come back to India after acquiring skills abroad, and on an average how long they stay abroad. What is the influence of Indian employees of these MNCs on the investment and other India specific decisions of the company? How do students, with comparable initial backgrounds, who pursue higher studies and professsional career in India and abroad, stack up against each other? The absence of such studies is all the more surprising since the issue in question is IITs and IIMs, which boast of excellent resources to carry out precisely such studies.
It is of course a different issue if the Government is concerned about the talent from IITs and IIMs not joining the public sector. A brain drain to the private sector, can be a more reasonable cause for concern. Are our best and brightest staying away from the Government sector? This is an issue which requires a different set of incentives. It strains credulity to accept that an exit tax will incentivize these graduates to stay on in India and join say, ISRO or BPCL, or pursue higher studies at IISc or the IITs.
There are evidently two objectives - deterring brain drain and cost recovery/revenue generation. Before we proceed any further, we need to examine whether these two objectives are desirable or not? Assuming the objectives are desirable, is the exit tax the best solution? If not, are there better solutions to achieving these objectives?
While revenue generation and cost recovery is a no brainer, I am not convinced of the need to deter brain drain. Brian drain can arise from graduate students pursuing higher studies in foreign, mainly US, universities, and those getting recruited by MNCs to work outside the country. The brain drain that results from students pursuing higher studies abroad, also generates very useful positive externalities. It is undeniable that those who go abroad for higher studies amass susbtantial value addition, for which there limited opportunities available in India. These talented individuals, exposed as they are to the best practices and latest technologies, and equipped with world-class professional expertise, have contributed immensely to the spectacular growth of our software and knwoledge based industries.
Many of them, graduates of our premier professional institutes, have returned back to India to capitalize on their professional expertise, either as part of the large number of MNCs operating here in various sectors, or by themselves starting companies. Those who have not returned yet, play a significant role in influencing, in our favor, the investment and other strategic decisions of MNCs and even Governments across the globe. Many of these graduates occupy the highest echelons of the private (and even Government) sector bureaucracy. They also form a significant proportion of the scientific manpower pursuing cutting edge research across the globe. It is arguably true that their foreign education and exposure to opportunities, which are unavailable in India even now, have catapulted them into their present status.
The multiplier effect on the Indian economy due to them is arguably many times more than the expenditure incurred in training them. In purely business terms, if India were a company and these graduates its investment, then the Chief Financial Officer of India would have to be given a hefty bonus for generating such handsome Returns on Investment (RoI). It will be interesting if some study can attempt quantifying the IRR on investment in these graduates!
The arguement against the other category of brain drain, to the private sector, is fallacious. At first sight, those graduates who take jobs abroad may appear to be a loss to our economy. But a closer scrutiny reveals that the graduates from IITs and in particular IIMs, invariably join private MNCs, who have operations across the globe. The highly skilled professional manpower of these companies increasingly belong to a category of "global employees", who frequently navigate across the geographical boundaries of operation of the company.
The dilemma we face is simple. Do we retain our best talent in India as semi-finished human resources or permit them to utilize all the opportunity available to realize their full potential? I am inclined to believe in the latter. We need to acknowledge the reality of a global workforce, unconstrained by the physical limitations imposed by national boundaries.
The arguement about cost recovery and revenue generation through the exit tax is a red herring. Even assuming full cost recovery from all the graduates from these institutions, we are talking about just a few crores of rupees, while the costs are substantial. Any tax causes distortions in the incentive structure. The issue we need to consider is whether the benefits of an exit tax by way of additional revenues, outweigh the costs incurred by way of distortion in the incentive structure.
I am convinced that any attempt at effectively utilizing these local talent to our advantage, without compromising on the full potential for value addition, has to be incentive compatible. Without the appropriate incentive structure, any regulatory approach will lead to sub-optimal outcomes. Further, in an age of the "global employee", it may not even be appropriate to look at individual talent as the exclusive property of any country. Knowledge industries are not circumscribed by the physical limitations of national or company boundaries and thrive on the free movement of ideas and people across nations and companies. Since India prides itself as a knowledge superpower, it may be ironical for us to impose restrictions on the free movement of our human talent.
In any case, simplistic supply side fixes to such social and economic problems generally fail. They do not properly appreciate the complex demand side, incentive structure that drives issues like brain drain.
With points and counter-points flying in all directions, it is imperative that the debate be illuminated by more informed analysis of facts. I am surprised that there is no empirical study of the likely consequences of an exit tax or the positive externality generated by brain drain. We need to compare and study large enough samples of students who have gone abroad for higher studies, jobs, and those who have stayed at home.
It would help if we could have reliable data on the proportion of these graduates who come back to India after acquiring skills abroad, and on an average how long they stay abroad. What is the influence of Indian employees of these MNCs on the investment and other India specific decisions of the company? How do students, with comparable initial backgrounds, who pursue higher studies and professsional career in India and abroad, stack up against each other? The absence of such studies is all the more surprising since the issue in question is IITs and IIMs, which boast of excellent resources to carry out precisely such studies.
It is of course a different issue if the Government is concerned about the talent from IITs and IIMs not joining the public sector. A brain drain to the private sector, can be a more reasonable cause for concern. Are our best and brightest staying away from the Government sector? This is an issue which requires a different set of incentives. It strains credulity to accept that an exit tax will incentivize these graduates to stay on in India and join say, ISRO or BPCL, or pursue higher studies at IISc or the IITs.
Thursday, September 6, 2007
Capturing willingness to pay
Some years back the Indian Railways introduced a Tatkal scheme, whereby passengers faced with an urgency and a willingness to pay, were given the option of purchasing their tickets just before the journey at a higher cost. This scheme became instant hit and was soon adopted by a number of other utilities. Today civic utilities like water, sewerage, and electricity connections are given on priority to those in immediate need of the service, for a premium. This premium reflects the additional cost incurred in delivering the service faster than the normal route.
The Tatkal scheme takes into account the varying needs and wants of customers for access to a particular service, and consequent differential willingness to pay of customers. The economic cost of the expedited service delivery is captured in the premiums demanded for its delivery.
Apart from its economic dimension, the Tatkal scheme also checks corruption and makes the process of service delivery more transparent. It is commonplace for corrupt officials to take bribes and expedite service delivery. The presence of citizens willing to pay the extra amount to access the service out-of-turn, only compounds the corruption problem. The Tatkal scheme, by legitimizing that additional payment, institutionalizes the informal arrangement.
The argument that this discriminates against the poor and those who cannot afford to access this service is fallacious. The Government has the obligation to deliver public services within a reasonable period of time. This arrangement has been institutionalized for the delivery of every service, by means of the Citizen Charter. Any service delivery which is out of turn and quicker than this schedule is obviously a privilege, and should rightly command a premium.
Following the Tatkal scheme, there are similar service delivery arrangements for a number of civic services in the Vijayawada Municipal Corporation (VMC). There is a well established Citizen Charter that governs the schedule for delivery of civic services in the normal course. Ever since the Citizen Charter was introduced, there have been numerous complaints that the counter staff and other VMC officials, accept bribe to expedite delivery of services. Citizens who want access to a particular service quicker and willing to pay a higher price for the service, offer this additional amount as bribe. In fact such an arrangement suits the rent-seeking officials perfectly, in so far as it gives them enough freedom to selectively deliver services. It also encourages them to expect similar rent payments from even those citizens who are not faced with the urgency and therefore unwilling to pay the premium.
Recently, a new expedited service delivery scheme has been started in the VMC for Birth and Death Registration, Building permissions, Property Tax assessment for new buildings, Mutations or title transfers, and water and UGD connections. The Corporation charges a small amount as premium for expedited delivery of these services. The huge response to this scheme only re-affirms the huge demand for expedited delivery of such services, which was hitherto being serviced by rent payments. It is also a reflection of the massive corruption that was latent in the system.
Similar price discrimination, which captures the differential willingness to pay of customers, can be adopted in many sectors of public service delivery. I am sure the day is not far off when price discrimination is adopted to sell railway tickets like that already in place for selling flight tickets. This becomes relatively easier with the provision of ticket sales through the Internet. The French state owned SNCF Railways is already issuing railway tickets by way of differential pricing.
The Tatkal scheme and its variants are a Pareto efficient arrangement and make certain categories of people happier or better off, without making anybody worse off. (In any case, the Citizen Charter schedule will be adhered to) It is also an economically efficient solution in so far as it generates additional revenue at no extra cost and also eliminates the distortions in the incentive structure that encouraged rent-seeking behaviour.
The Tatkal scheme takes into account the varying needs and wants of customers for access to a particular service, and consequent differential willingness to pay of customers. The economic cost of the expedited service delivery is captured in the premiums demanded for its delivery.
Apart from its economic dimension, the Tatkal scheme also checks corruption and makes the process of service delivery more transparent. It is commonplace for corrupt officials to take bribes and expedite service delivery. The presence of citizens willing to pay the extra amount to access the service out-of-turn, only compounds the corruption problem. The Tatkal scheme, by legitimizing that additional payment, institutionalizes the informal arrangement.
The argument that this discriminates against the poor and those who cannot afford to access this service is fallacious. The Government has the obligation to deliver public services within a reasonable period of time. This arrangement has been institutionalized for the delivery of every service, by means of the Citizen Charter. Any service delivery which is out of turn and quicker than this schedule is obviously a privilege, and should rightly command a premium.
Following the Tatkal scheme, there are similar service delivery arrangements for a number of civic services in the Vijayawada Municipal Corporation (VMC). There is a well established Citizen Charter that governs the schedule for delivery of civic services in the normal course. Ever since the Citizen Charter was introduced, there have been numerous complaints that the counter staff and other VMC officials, accept bribe to expedite delivery of services. Citizens who want access to a particular service quicker and willing to pay a higher price for the service, offer this additional amount as bribe. In fact such an arrangement suits the rent-seeking officials perfectly, in so far as it gives them enough freedom to selectively deliver services. It also encourages them to expect similar rent payments from even those citizens who are not faced with the urgency and therefore unwilling to pay the premium.
Recently, a new expedited service delivery scheme has been started in the VMC for Birth and Death Registration, Building permissions, Property Tax assessment for new buildings, Mutations or title transfers, and water and UGD connections. The Corporation charges a small amount as premium for expedited delivery of these services. The huge response to this scheme only re-affirms the huge demand for expedited delivery of such services, which was hitherto being serviced by rent payments. It is also a reflection of the massive corruption that was latent in the system.
Similar price discrimination, which captures the differential willingness to pay of customers, can be adopted in many sectors of public service delivery. I am sure the day is not far off when price discrimination is adopted to sell railway tickets like that already in place for selling flight tickets. This becomes relatively easier with the provision of ticket sales through the Internet. The French state owned SNCF Railways is already issuing railway tickets by way of differential pricing.
The Tatkal scheme and its variants are a Pareto efficient arrangement and make certain categories of people happier or better off, without making anybody worse off. (In any case, the Citizen Charter schedule will be adhered to) It is also an economically efficient solution in so far as it generates additional revenue at no extra cost and also eliminates the distortions in the incentive structure that encouraged rent-seeking behaviour.
Monday, September 3, 2007
Capital gains is no different from other incomes
The case for concessions on long term capital gains is that it would encourage saving and investment and make the economy perform better in the long run. There is however, not a great deal of evidence that reducing tax rates on long-term capital gains has made much difference in saving or investment. In case of real estate, as is evidenced by developments in many Indian cities (witness Hyderabad), massive investments have been made in just amassing land, without any productive economic activity. Increasingly greater proportion of investments and effort in the equity markets is going towards speculative trading activity, rather than adding to the productive capacity of the economy.
My contention is that capital gains on assets - land, buildings, shares and bonds, financial market related investments etc - are determined more by factors outsde the control of human beings and hence need to be differentiated from gains and incomes from entrepreneurship and individual or collective effort. The recent spate of asset booms across the world, sparked off by "irrational exuberance" in real estate and equity markets, have opened up the debate on capital gains taxation. The buccaneering role of the hedge fund managers and private equity firms and the benefits showered on them have made the debate livelier still.
The proponents of capital gains taxation argue that any capital gains tax exemption is unfair in so far as it treats wealth and effort differently. Let us examine the two major sources of capital gains today - real estate and the financial markets. It is unargubaly true that chance and randomness dictates fortunes in both these markets. A Black Swan event does not discriminate between types of investors, and can either make fortunes for even small investors or wipe off the entire investment of even the most "intelligent" investors. More than any personal effort, it is lady luck and also the privilege by way of access to better information and the systems to analyze it, that gives our superstar investors their higher capital gains. And this too is fleeting and suspect.
The real estate market is even more a game of luck and chance. Generally, land value appreciation has little to do with the developments on the land and any efforts of the land owner. It is almost exclusively dependent on developments around the land, like development of new civic infrastructure, or new capital investment in any economic or commercial activity in its vicinity. The land owner appropriates a disproportionately large share of the land value appreciation as an unearned increment.
Any system of taxation has to be seen as being fair and rewarding effort. By this yardstick, a large share of capital gains taxation is surely not very fair. With the economy firmly enscocned in the "Age of Asset Bubbles", the time may have come to have a re-look at the principles underlying concessions on capital gains taxation. This assumes even greater importance in light of ever increasing evidence that the taxation policies in vogue today have contributed in no small measure towards increasing inequality.
Update
John Kay writing in the FT, The capital gains tax change will not deter enterprise,argues against tax breaks on capital gains.
My contention is that capital gains on assets - land, buildings, shares and bonds, financial market related investments etc - are determined more by factors outsde the control of human beings and hence need to be differentiated from gains and incomes from entrepreneurship and individual or collective effort. The recent spate of asset booms across the world, sparked off by "irrational exuberance" in real estate and equity markets, have opened up the debate on capital gains taxation. The buccaneering role of the hedge fund managers and private equity firms and the benefits showered on them have made the debate livelier still.
The proponents of capital gains taxation argue that any capital gains tax exemption is unfair in so far as it treats wealth and effort differently. Let us examine the two major sources of capital gains today - real estate and the financial markets. It is unargubaly true that chance and randomness dictates fortunes in both these markets. A Black Swan event does not discriminate between types of investors, and can either make fortunes for even small investors or wipe off the entire investment of even the most "intelligent" investors. More than any personal effort, it is lady luck and also the privilege by way of access to better information and the systems to analyze it, that gives our superstar investors their higher capital gains. And this too is fleeting and suspect.
The real estate market is even more a game of luck and chance. Generally, land value appreciation has little to do with the developments on the land and any efforts of the land owner. It is almost exclusively dependent on developments around the land, like development of new civic infrastructure, or new capital investment in any economic or commercial activity in its vicinity. The land owner appropriates a disproportionately large share of the land value appreciation as an unearned increment.
Any system of taxation has to be seen as being fair and rewarding effort. By this yardstick, a large share of capital gains taxation is surely not very fair. With the economy firmly enscocned in the "Age of Asset Bubbles", the time may have come to have a re-look at the principles underlying concessions on capital gains taxation. This assumes even greater importance in light of ever increasing evidence that the taxation policies in vogue today have contributed in no small measure towards increasing inequality.
Update
John Kay writing in the FT, The capital gains tax change will not deter enterprise,argues against tax breaks on capital gains.
"Studies of entrepreneurs – and their own accounts – suggest they may be really different. Establishing a business is hard work and the people who succeed are fired by enthusiasm for business in general and their own, in particular. The capital gains tax on an eventual sale is rarely at the front of their minds.
There is a large difference, in motivation and in achievement, between the originator of a new or differentiated product or service and the supporter – whether venture capitalist or office fitter. The interest of the latter is in the money the business will make rather than in the business activity itself. Both the entrepreneur and the supporter are necessary, but the first is the unique dynamic of the capitalist economy and the second the product of a competitive market. Where the first is found, the second will follow."
Sunday, September 2, 2007
Carried interest and capital gains tax concessions
There is a raging debate going on about whether publicly traded partnerships in the US should be given concessionary treatment on taxation. "Carried interest", the focus of this attention, is the tax levied on partners for the profit earned by them, while managing the assets of other individuals.
In such partnerships, the managers usually operate as a partnership, representing the general partners running the PE firm or hedge fund. The general partners run the PE firm on behalf of the limited partners, who are the high net worth investors. Typically the general partners put up about 5% of the capital, and get an annual fee of 2% of assets under management for management services and 20% of the cumulative profits on the investments. The former is taxed as ordinary income, while the latter, called "carried interest", is classified as long-term capital gains and taxed only 15%.
According to the existing taxation rules in the US, private and publicly traded partnerships are required to pay long-term capital gains tax of only 15%, as against the regular corporate tax rate of 35%. This tax benefit is an extension of the long term capital gains tax concessions given to investors in financial equity. Critics point out that there is a significant difference between private investors (limited partners) and the general partners of PE firms and hedge fund managers. While the former are risking their own capital, the latter are managing the assets of other people. They are not risking their capital, and are paid for their expertise (this is itself a moot point!) in managing these assets with 20% of the total profits made by the Fund. If this logic were to be extended, any employee of a Pension Fund or Mutual Fund ought to be extended this tax concession.
In early June this year, Senators Max Baucus and Charles Grassley introduced a legislation to remedy this anomaly, aimed at publicly traded partnerships like the Blackstone Group (informally dubbed Blackstone's law). The law, if passed, would ensure that publicly held partnerships would also pay taxes as an ordinary corporation rather than as a partnership.
This debate has also generated a demand that even the privately held partnerships like the massively profitable private equity firms and hedge funds, should also pay the regular corporate tax. Those in favor of scrapping any tax benefits argue that there is no reason why partnerships should get a benefit which is denied to an entrepreneur. There is also the contention that "carried interest" is a component of management fee and is not a capital gains, since the overwhelmingly major share of investment is by the limited partners.
Paul Krugman argues in his New York Times column, "Why does Henry Kravis pay a lower tax rate on his management fees than I pay on my book royalties?" Krugman hits the nail on its head. Increasingly, with massive leveraging, the share of proprietary capital in the total investments of private equity firms, are a small proportion.
One of the fundamental principles of taxation is that it should be fair and economically efficient. This means that effort and not luck needs to be our central concern and it should be rewarded appropriately. I have an issue here with not just the tax concessions given to private and publicly traded partnerships, but with tax benefits on capital gains itself. A detailed elaboration of this position in the next post.
Update 1 (5/4/2010)
The annual survey by AR: Absolute Return +Alpha magazine finds that the top 25 provate equity and hedge fund managers earned $25.3 billion in 2009, including fees and capital gains. Leading the pack, David Tepper of Appaloosa Management made $4 billion, in part by betting successfully that the government would bail out the big banks. John Paulson, of Paulson & Company, made $2.3 billion by buying back bank stocks he shorted in 2008. And a year after his fund received $200 million in the bailout of the American International Group, Kenneth Griffin of the Citadel Investment Group made $900 million.
Some hedge fund managers and, more commonly, private equity fund managers are able to pay a much lower rate of tax, as capital gains tax, than the typical working professional. The tax disparity results from an outdated rule that lets a money manager in a private partnership treat a chunk of his fees as if they were long-term capital gains, taxed at a special low rate of 15%. It has been argued that fees for managing someone else’s money should be taxed as ordinary income, like wages and salary, at rates as high as 35%.
President Obama has included a provision to end that special treatment in his most recent budget. For three years running, the House has passed a bill to close the loophole. In the Senate both Democrats and Republicans have resisted, all for fear of losing lucrative campaign donations.
In such partnerships, the managers usually operate as a partnership, representing the general partners running the PE firm or hedge fund. The general partners run the PE firm on behalf of the limited partners, who are the high net worth investors. Typically the general partners put up about 5% of the capital, and get an annual fee of 2% of assets under management for management services and 20% of the cumulative profits on the investments. The former is taxed as ordinary income, while the latter, called "carried interest", is classified as long-term capital gains and taxed only 15%.
According to the existing taxation rules in the US, private and publicly traded partnerships are required to pay long-term capital gains tax of only 15%, as against the regular corporate tax rate of 35%. This tax benefit is an extension of the long term capital gains tax concessions given to investors in financial equity. Critics point out that there is a significant difference between private investors (limited partners) and the general partners of PE firms and hedge fund managers. While the former are risking their own capital, the latter are managing the assets of other people. They are not risking their capital, and are paid for their expertise (this is itself a moot point!) in managing these assets with 20% of the total profits made by the Fund. If this logic were to be extended, any employee of a Pension Fund or Mutual Fund ought to be extended this tax concession.
In early June this year, Senators Max Baucus and Charles Grassley introduced a legislation to remedy this anomaly, aimed at publicly traded partnerships like the Blackstone Group (informally dubbed Blackstone's law). The law, if passed, would ensure that publicly held partnerships would also pay taxes as an ordinary corporation rather than as a partnership.
This debate has also generated a demand that even the privately held partnerships like the massively profitable private equity firms and hedge funds, should also pay the regular corporate tax. Those in favor of scrapping any tax benefits argue that there is no reason why partnerships should get a benefit which is denied to an entrepreneur. There is also the contention that "carried interest" is a component of management fee and is not a capital gains, since the overwhelmingly major share of investment is by the limited partners.
Paul Krugman argues in his New York Times column, "Why does Henry Kravis pay a lower tax rate on his management fees than I pay on my book royalties?" Krugman hits the nail on its head. Increasingly, with massive leveraging, the share of proprietary capital in the total investments of private equity firms, are a small proportion.
One of the fundamental principles of taxation is that it should be fair and economically efficient. This means that effort and not luck needs to be our central concern and it should be rewarded appropriately. I have an issue here with not just the tax concessions given to private and publicly traded partnerships, but with tax benefits on capital gains itself. A detailed elaboration of this position in the next post.
Update 1 (5/4/2010)
The annual survey by AR: Absolute Return +Alpha magazine finds that the top 25 provate equity and hedge fund managers earned $25.3 billion in 2009, including fees and capital gains. Leading the pack, David Tepper of Appaloosa Management made $4 billion, in part by betting successfully that the government would bail out the big banks. John Paulson, of Paulson & Company, made $2.3 billion by buying back bank stocks he shorted in 2008. And a year after his fund received $200 million in the bailout of the American International Group, Kenneth Griffin of the Citadel Investment Group made $900 million.
Some hedge fund managers and, more commonly, private equity fund managers are able to pay a much lower rate of tax, as capital gains tax, than the typical working professional. The tax disparity results from an outdated rule that lets a money manager in a private partnership treat a chunk of his fees as if they were long-term capital gains, taxed at a special low rate of 15%. It has been argued that fees for managing someone else’s money should be taxed as ordinary income, like wages and salary, at rates as high as 35%.
President Obama has included a provision to end that special treatment in his most recent budget. For three years running, the House has passed a bill to close the loophole. In the Senate both Democrats and Republicans have resisted, all for fear of losing lucrative campaign donations.
Saturday, September 1, 2007
Incentives sustaining marriages
So it appears that one of the last bastions of human relationship has fallen at the altar of mammon. There is an article in the Guardian dated 31.08.2007 "Love and Divorce", which quotes a recent report of the British Office for National Statistics, which finds divorce rates across England and Wales steadily declining. The conservatives will surely seize on this as conclusive proof of strengthening familial and social bonds. But a more probable reason for the decline, claims the article, appears to be financial concerns. It quotes Alex Carruthers, of City law firm Hughes Fowler Carruthers, as saying: "A lot of men whose marriages are in a bad patch come to us and say they have seen the headline-grabbing cases. They ask what those cases would mean for them if they divorce and when they get the bad news, they generally say 'OK, I'll put it on hold'."
The article also says, "Previously a wife at home was not expected to win an equal portion of her working husband's assets, but since high-profile rulings in 2000, both the court of appeal and House of Lords have fashioned the starting point at 50:50 for both the homemaker and the breadwinner." Another example of the power of incentives!
The article also says, "Previously a wife at home was not expected to win an equal portion of her working husband's assets, but since high-profile rulings in 2000, both the court of appeal and House of Lords have fashioned the starting point at 50:50 for both the homemaker and the breadwinner." Another example of the power of incentives!
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