Wednesday, June 30, 2021

Corruption and renegotiations in infrastructure - case of Oderbrecht

I have blogged on several occasions pointing to the problem of renegotiations that plague infrastructure contracts. While the theory and anecdotal evidence is well-known, empirical evidence on this has been scarce. 

In this context, Eduardo Engel, Nicolas Campos, and co-authors have an excellent paper on the Oderbrecht corruption scandal, often described as by far the largest cross-country corruption scam in history. This description conveys the scale, 

The Odebrecht case leaves you speechless. This case implicated almost one-third of Brazil’s senators and almost half of all Brazil’s governors. A single company paid bribes to 415 politicians and 26 political parties in Brazil. It makes the Watergate scandal look like a bunch of kids playing in a sandbox.

Its political implications were unprecedented across Latin America,

The plea agreement between the US Department of Justice and Odebrecht triggered judicial investigations in several countries, leading to plea bargains and additional disclosures of political corruption. In Peru, President Pedro Pablo Kuczynski was forced to resign, and of the three previous Peruvian Presidents, Alan García committed suicide, Alejandro Toledo fled the country, and Ollanta Humala spent time in jail. In Brazil, former president Luis Inácio Lula da Silva spent 19 months in prison in connection with alleged bribe payments made by rival construction firm OAS; in Ecuador, former vice-president Jorge Glas was sentenced to six years in jail. The Odebrecht case may have weakened the confidence of the public in democracy and helped lead to the current wave of populism in Latin America.

An elaborate system was put in place within the company to manage the bribe transactions,

By 2006, bribery at Odebrecht had become so institutionalized that the company created the Division of Structured Operations (DSO), a stand-alone department dedicated to corruption. According to the plea agreement between the Odebrecht chief executive officer Marcelo Odebrecht and the US Department of Justice, the DSO specialized in buying influence through legal and illegal contributions to political campaigns and also in paying bribes to public officials and politicians. Within the DSO, three full-time executives and four experienced assistants were responsible for paying bribes to foreign accounts. Bribe payments followed a clear organizational flow. A contract manager would deal with potential bribe recipients—public officials and politicians—and reported to the country manager. The country manager could approve small bribes paid with local funds. Larger bribes were vetted by an executive reporting directly to the Odebrecht chief executive officer who often made the final decision.
Once a bribe was authorized, the Division of Structured Operations registered, managed, and made the payment through a network of shell companies, off-book transactions, and off-shore bank accounts. This included the Antigua subsidiary of Austria’s Meinl Bank, bought for this purpose by Odebrecht. The DSO also used an independently funded parallel cash trove (called Caixa 2). As the US Department of Justice (2016) described the arrangements: “[T]o conceal its activities, the Division of Structured Operations utilized an entirely separate and off-book communications system . . . to communicate with one another and with outside financial operators . . . via secure emails and instant messages, using codenames and passwords.” The DSO also used a bespoke information management system for bookkeeping and to track information flows.

The company bribed to both win contracts and renegotiate them,

Odebrecht bribed to tailor auctions in its favor and to obtain favorable terms when renegotiating the contract after the projects were awarded... Odebrecht had bribed about 600 politicians and public servants in ten Latin American countries to win the public bidding process of large infrastructure projects, and to renegotiate the projects at higher prices after winning them... Odebrecht distorted the firm selection process in various ways. The evaluation of the technical expertise of participants was often biased in projects that were tendered competitively. For example, if the technical score was a weighted average of objective and subjective components, the weights would be chosen to favor Odebrecht. Alternatively, Odebrecht could be arbitrarily awarded the highest possible technical score, while its competitors received a lower score. In other cases, potential bidders were disqualified by setting technical requirements that only Odebrecht could meet... 
First, for 46 of the 62 projects where we found evidence of a quid pro quo, Odebrecht bribed to manipulate subjective bid criteria to either exclude or disadvantage rivals. Second, in 30 projects, Odebrecht bribed to obtain better terms when renegotiating the contract after the projects were awarded. Third, in nine projects, Odebrecht paid a bribe because a public official threatened to block the project. Extortion has been mentioned in the literature as a reason to pay bribes, but it is less frequent in the Odebrecht case. For 27 out of the 62 projects for which we found evidence of the quid pro quo, more than one of these reasons applied.

Many contracts were renegotiated multiple times, sometimes even ten times. 

The biggest contribution of the paper is in making empirical estimates of the returns from bribing to renegotiate infrastructure contracts,

The US Department of Justice was able to estimate gross profits made by paying bribes in each country— “any profit earned on a particular project for which a profit was generated as the result of a bribe payment”... Odebrecht paid $786 million in bribes and obtained gross profits equal to $3,160 million. That is, Odebrecht made $3 in net profits for every $1 it paid in bribes... For the eight countries with complete data at the top panel of the table, cost increased by 40.1 percent after renegotiations, with substantial variation across countries and projects. For the 105 projects from Brazil for which we have data, costs increased by 17.4 percent... in the 26 projects with no bribes, costs increased by a weighted average of 5.6 percent after renegotiations (simple average 16.3 percent). In contrast, in the 62 projects where Odebrecht paid bribes, costs rose by 70.8 percent after renegotiations. Thus, cost increases in renegotiations are about 12 times larger when Odebrecht paid a bribe.
... repeating the computations using only legal documents... Odebrecht paid bribes in 45 projects. Now the amount renegotiated increases from 10.9 percent when there are no bribes, compared to 84.9 percent with bribes. Data from the Odebrecht projects in Brazil for which we could obtain information also show that renegotiations were larger when bribes were paid, even though cost increases were smaller overall. Specifically, using legal and media sources to detect bribe payments, we find that renegotiations in projects with bribes led to a cost increase of 18.9 percent compared with 4.1 percent for projects without bribes (both weighted averages). If instead we consider simple averages, the percentages are 24.5 and 6.2 percent, respectively. Again, as a robustness check, if we only consider legal sources to determine whether bribes were paid, the above percentages are 18.8 versus 6.2 percent for weighted averages (or 24.6 versus 6.9 percent for simple averages).

This estimate of the extent of corruption in infrastructure projects is useful,

Kenny (2009) concludes that bribes in the infrastructure sector are between 5 and 20 percent of construction costs while Glaeser (2019) reports that highway cost overruns due to corruption lie between 20 and 30 percent of project cost. Olken (2007) measured the difference between what an Indonesian village government spent on a road and a cost estimate by expert engineers. Unaccounted expenditures averaged approximately one-fourth of the total cost of the road. Collier, Kirchberger, and Söderbom (2016) showed that the unit cost of roads is 15 percent higher in countries where corruption, as measured by the World Governance Indicators, is above the median. In 2004 the American Society of Civil Engineers claimed that corruption accounts for an estimated $340 billion of worldwide construction costs each year, around 10 percent of the global construction industry value added of $3.2 trillion.

But in case of Oderbrecht, also given the larger project sizes, bribes as a share of project cost was very small, less than 1%. 

Everything in this paper applies to infrastructure and PPP contracting across the world, developing and developed countries. In developing countries, like with Brazil, the rent-seeking is often direct. Officials  subvert technical qualification norms or favour contractors in the terms of renegotiations, in return for direct payments of bribes. 

But in developed countries, it comes in the more sophisticated forms, with less of explicit cash transfers. One route is the close nexus between consultants who assist governments with bid process management and contracting. I have blogged here how consultants have become the new brokers for rent-seeking, the conduits for influence peddling and bribery in large projects. 

The long-term nature of PPP concessions is attractive for rent-seeking. Unlike a public construction contract where the bribery is confined to winning the contract (and therefore to the party/government in power when the tender was finalised), a concession offers rent-seeking opportunities throughout the project lifecycle. So, after the project is constructed, the concessionaire often comes back to renegotiate on investment commitments or operation and maintenance (O&M) terms or something else. These renegotiations span the tenures of successive governments, allowing each of them to benefit from the stream of renegotiation interfaces for each project.

There is another impressive aspect to the Oderbrecht case. It's the minute details of transactions which have been uncovered and evidence gathered to prosecute so many high profile leaders across countries. This must rank as one of the most impressive anti-corruption campaigns in history, one where the investigators, prosecutors and the judiciary have all acquitted themselves with remarkable effectiveness. 

It's also a lesson to anti-corruption agencies, prosecutors, and judges in India, where even the elite institutions like the CBI struggle to succeed in prosecuting in even the most egregious cases. The Courts must take their due share of the blame for this remarkable track record of such consistent failure. 

Monday, June 28, 2021

Market concentration in Main Street and Wall Street

I have blogged earlier about Hendrik Bessembinder, the Arizona University Professor, whose research has shown that almost all the stock market returns over history have come from a handful of stocks. His work has been embraced by a few fund managers to justify single-minded pursuit of picking high growth stocks. As Bessembinder himself has written, it has been embraced by both sides,

One observer reacted by saying that the paper was “another nail in the proverbial stock picker’s coffin” while another interpreted the findings to support “giving yourself the best possible chance of owning a small number of outliers”... One writer pronounced that I argued that “the only way to invest is via index or exchange traded funds” while a Financial Times newspaper headline said I advocated “a shot at the moon”.

Though this is central to the assumptions of either side,

The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such ‘home run’ stocks, or can identify a manager with the skill to do so, remains.

He found that despite the large equity market gains over the past century in the US, most stocks were duds (see this paper),  

In fact, of the roughly 26,000 companies listed between 1926 and 2016, more than half lost money or did worse than simply holding one-month Treasuries. In contrast, about 1,000 stocks — or just 4 per cent of the entire sample — in practice accounted for all the net wealth creation over the period, or almost $35tn.

In fact, he found that these trends were increasing in the US,

The study includes all of the 26,168 firms with publicly-traded U.S. common stock since 1926. Despite the fact that investments in the majority (57.8%) of stocks led to reduced rather than increased shareholder wealth, U.S. stock market investments on net increased shareholder wealth by $47.4 trillion between 1926 and 2019. Technology firms accounted for the largest share, $9.0 trillion, of the total, but Telecommunications, Energy, and Healthcare/ Pharmaceutical stocks created wealth disproportionate to the numbers of firms in the industries. The degree to which stock market wealth creation is concentrated in a few top-performing firms has increased over time, and was particularly strong during the most recent three years, when five firms accounted for 22% of net wealth creation.

And he found that the skewed nature of stock market returns were even more extreme outside the US

We study compound returns to nearly 62,000 global common stocks during the 1990 to 2018 period, documenting that the majority, 56% of US stocks and 61% of non-US stocks, under perform one-month US Treasury bills over the full sample. Focusing on aggregate shareholder wealth creation measured in US dollars, we find that the top-performing 1.3% of firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018. Outside the US, less than one percent of firms account for the $US 16.0 trillion in net wealth creation. These results highlight the practical implications of the fact that the distribution of long-run stock returns is strongly positively skewed.

In this context, the concentration of returns is evident in the Indian markets too. Ananth points to this article from Marcellus Investment Managers. This about profit concentration in corporate India,

A handful of companies – precisely TEN – are now taking home almost the entire PAT generated by the Indian stock market. This profit concentration in the hands of the top 10 companies has quintupled in the past decade and it has nothing to do with Quantitative Easing (QE) by central banks. Fewer and fewer companies – precisely TWENTY – now account for around 55% of the Free Cashflow to Equity generated by the Indian stock market. A decade ago, the top 20 Free Cashflow generators accounted for around 41% of India’s FCFE. Once again this has nothing to do with QE...
The top 20 profit generators in India (‘the Leviathans’) now account for 90% of the country’s corporate profits. Beyond dominating the country’s profit pool, the Leviathans also reinvest these profits far more efficiently back into their businesses. In fact... India’s top 20 PAT generators not only account for 90% of the nation’s profits, but they also take home 45% of the nation’s Free Cashflow to Equity (or FCFE, which is the amount of cash generated by a business and available to its shareholders after payment of debt, expenses, and investments). The reason for the lower share of the Leviathans in FCFE rather than PAT is because these giant companies are heavily reinvesting their PAT to fuel future growth. This reinvestment reduces their FCFE.

An earlier article in the same site points to more signatures of concentration,
The last decade has seen a steady rise in the ROE superiority of the top 20 Leviathans. In FY20, the median ROE of the top 20 Leviathans was 17.2% whereas India Inc’s average ROE was a mere 4%! This means that the top 20 firms are not just putting greater amounts of money to work, they are also applying these larger sums of money far more effectively and far more profitably than the rest of India.


And this about concentration in the Indian equity markets,

In the decade ending 31st December 2010, the Nifty added around Rs. 35 trillion in market cap. In these ten years, 80% of the value generated came from 26 companies and the median Total Shareholder Return (TSR) CAGR was 34% for these 26 companies. Moving forward by a decade, in the decade ending December 31st, 2020, the Nifty added Rs. 71 trillion in market cap. 80% of the value generated in these ten years came from just 16 companies whose median TSR CAGR was 21%.

The authors at Marcellus points to drivers of such market concentration - nature of intangibles or knowledge based industries compared with brick and mortar industries, network effects, self-reinforcing nature of the impacts of modern technologies, superior access to talent etc. You could add more like globalisation and emergence of global markets. 

However, all these are only part of the explanation. There is more at play. The rules of the game of modern capitalism and political systems favour the larger firms disproportionately. The taxation regime (corporate tax, capital gains/buybacks, tax deductibility on interest expenses etc), ease of financing (lower cost of capital for the largest firms), the public bailout backstop (too big to fail), public policy dominance of stock markets health over that of real markets, and so on are examples. Most disturbingly, the setting of these rules themselves are captured by the same elite companies. And therein lies the risk to the sustainability of modern capitalism.

Update 1 (10.08.2021)

Business Standard points to increased business concentration across sectors during the Covid pandemic in India. It uses the Herfindahl-Hirschman Index (HHI) scores to map business concentration (an industry with HHI of greater than 2500 is highly concentrated, and one below 1500 to be competitive). 

Saturday, June 26, 2021

Weekend reading links

1. Debashis Basu draws attention to this,

One of the most egregious recent cases of misconduct is the behaviour of credit-rating agencies. YES Bank AT1 Bonds, DFHL, and IL&FS all sported AAA or AA+ ratings just months before they went bust. A fortnight before IL&FS went bust in September 2018, the rating-agencies India Ratings, ICRA, and CARE had all given its debt papers AAA/AA+ ratings, even when its subsidiary, IL&FS Transport Networks, had defaulted in June the same year. Investors looking for safe investment have lost billions of rupees due to the ratings. And yet, the Securities Appellate Tribunal (SAT) seems to think this is simple carelessness.

Last week, SAT reduced the penalty imposed by the Securities and Exchange Board of India (Sebi) on CARE Ratings from Rs 1 crore to Rs 10 lakh in a case related to lapses in assigning a credit rating to non-convertible debentures of Reliance Communications (RCom). SAT felt this was a case of “lack of due diligence for not having acted in a timely manner … the maximum penalty of Rs 1 crore is highly excessive, harsh and arbitrary and (is) not commensurate with the violation”. After all, it is not that the ratings were not downgraded, pointed out SAT, “but not in a timely manner. There could be a case of carelessness or sluggishness or laxity … but it is not a case of oversight”.

When you have orders like this, it's no surprise that financial market regulation remains weak. This is also yet another example from India's disappointing experience with appellate tribunals. It's a reminder to market enthusiasts like those who formulated the Indian Financial Code that theory and practice often diverge to the detriment of the system. 

In this context, I had blogged here outlining the case against having appellate tribunals to adjudicate on regulatory decisions by financial market regulators like RBI, SEBI, or IRDA. 

2. Ashok Gulati writes about the unsustainability of rice and sugar exports by India, pointing to their very high water consumption. 

It is well known that a kg of sugar has a virtual water intake of about 2,000 litres. In 2020-21, India exported 7.5 million tonnes of sugar, implying that at least 15 billion cubic metres of water was exported through sugar alone. Another water guzzler, rice, needs around 3,000 to 5,000 litres of water for irrigating a kg, depending upon topography. Taking an average of about 4,000 litres of water per kg of rice, and assuming that half of this gets recycled back to groundwater, exporting 17.7 million tonnes of rice means that India has virtually exported 35.4 billion cubic metres of water just through rice.

3. India is not alone in its import dependence on China. But given the border issues, India's dependence assumes even greater significance. Sample this,

Two categories topped Chinese imports during 2019-20 (the latest disaggregated data): “electrical machinery and equipment and parts thereof; sound recorders and reproducers, television image and sound recorders and reproducers, and parts" ($19.1 billion), and “nuclear reactors, boilers, machinery and mechanical appliances; parts thereof" ($13.32 billion), amounting to almost 50% of the total Chinese imports that year. China has already supplied a significant chunk of India’s installed turbine-boiler-generator capacity, sweetening the deal with dirt-cheap financing. The critical question here is: Can the private sector in the West finance Indian infrastructure at comparably low rates?

This raises some questions. One, notwithstanding all the blame that will reflexively get laid at the doorstep of the government, the electrical and electronics imports are clearly an indictment of India's private sector. They've had three decades since the liberalisation to get this right, but due to lack of entrepreneurship, risk appetite, and ambition, they have instead allowed the sector to be dominated by foreign competitors (especially Chinese). It's stunning that the landscape of even consumer durables in India, including the new category of mobile phones, is dominated by foreign brands. For a large country, it surely cannot be that the government is to blame for this. 

Second, the infrastructure equipment story raises a conundrum. Given the lower cost of Chinese equipment, is there a case that the lower cost imports are alright since it would also lower the life-cycle cost of the infrastructure service? Or do the risks outweigh the benefits from lower life-cycle cost? And in cases like solar, it's an indictment that, despite the presence of the likes of Adani Group, Indian module/cell manufacturing has been so poor.

4. When Abiy Ahmed took over as Ethiopia's Prime Minister, he was hailed as the next great African hope, and even won a Nobel Prize. Just two years later, the fall from grace is near complete.

5. Livemint writes about the rise of start-ups and their financing in tier 2 and 3 cities of India,

According to data from Tracxn, a business intelligence platform, nearly 3,700 startups were launched from tier-2 and tier-3 cities in 2020, which cumulatively raised as much as $3 billion from investors. In the current year until May, a total of 120 startups have been founded in such towns. Cumulatively, these startups have raised as much as $2.25 billion, showing that the per-deal average has increased in 2021. Among sectors, the consumer technology vertical saw the highest number of new ventures in the last couple of years. It was followed by fintech, food/agriculture and travel/hospitality.

Even if majority of the financing is aimed at services and little towards manufacturing, it's a good thing that formal financing is finding its way into funding risk endeavours in smaller cities and towns of India. This is an important outlet for mobilisation of risk capital that would otherwise have gone into speculative activities like real estate. Sample this

In Maharashtra’s Amravati, chartered accountant Mayur Zanwar, 40... decided to put money in other startups. Till date, he has invested in nearly 20 ventures. He liquidated all of his real estate holdings last year to increase his bets on the startup segment and aims to invest in as many as 30 early-stage ventures by the end of 2021.

6. The deal involving the majority ownership takeover of PNB Housing by Carlyle Group through allotment of preferential shares worth Rs 4000 Cr has generated controversy. Following an advisory firm's report, SEBI stepped in and directed that the deal be done only after a valuation by an independent entity.

PNB Housing is a public sector undertaking (PSU) because it is promoted by PNB, a public sector bank. PSUs command considerably low valuation in the stock market compared to their private sector peers because of a variety of reasons, such as the style of functioning and government interference. Since the control will change after the deal, an independent valuation of the firm was critical. The PNB Housing board kept the allotment price in tune with the Sebi rules, but rather strangely did not factor in any premium for the control it was ceding. In fact, the share price nearly doubled after the deal announcement, though it has corrected recently because of the uncertainty over the deal. The stock market has re-rated the stock to account for a change in control... Even if the board was convinced that there was no case for such a premium, it should have followed good governance practices and got the deal vetted by an independent valuer instead of its own auditor. This would have not only made the deal more transparent and acceptable but would have also absolved some of the directors of the accusation that it was influenced by their links with Carlyle Group in the past.

7. Questions are being raised and evidence to the contrary is building up about the efficacy of the Chinese vaccines,

In the Seychelles, Chile, Bahrain and Mongolia, 50 to 68 percent of the populations have been fully inoculated, outpacing the United States, according to Our World in Data, a data tracking project. All four ranked among the top 10 countries with the worst Covid outbreaks as recently as last week, according to data from The New York Times. And all four are mostly using shots made by two Chinese vaccine makers, Sinopharm and Sinovac Biotech... In the United States, about 45 percent of the population is fully vaccinated, mostly with doses made by Pfizer-BioNTech and Moderna. Cases have dropped 94 percent over six months. Israel provided shots from Pfizer and has the second-highest vaccination rate in the world, after the Seychelles. The number of new daily confirmed Covid-19 cases per million in Israel is now around 4.95. In the Seychelles, which relied mostly on Sinopharm, that number is more than 716 cases per million...
China, as well as the more than 90 nations that have received the Chinese shots, may end up... contending with rolling lockdowns, testing and limits on day-to-day life for months or years to come. Economies could remain held back. And as more citizens question the efficacy of Chinese doses, persuading unvaccinated people to line up for shots may also become more difficult... Mongolia has now vaccinated 52 percent of its population. But on Sunday, it recorded 2,400 new infections, a quadrupling from a month before... a Sinovac study out of Chile showed that the vaccine was less effective than those from Pfizer-BioNTech and Moderna at preventing infection among vaccinated individuals.
The much hyped vaccine diplomacy of China, far from furthering the country's soft power, may have only reinforced the stereotypes about Chinese products being of inferior quality.

This is an important episode in so far as it highlights the possibility that the much hyped Chinese catch-up in technology frontiers may be less than factual. 

8. Labour markets in the US have been flashing signatures of increasing wages. Sample this from an article which points to Amazon's massive hirings and that too at $15 an hour having an upward effect on wages,
Non-supervisory roles have seen strong wage gains in recent months, while New York Federal Reserve surveys show that the average lowest wage that workers with no college degree say they will accept for a new job has jumped by 19 per cent since before the pandemic hit — the sharpest such increase since at least 2014.

It remains to be seen how persistent would be this trend. It's too early to argue that this marks a reversal of a long period of labour wage compression relative to capital income. 

9. Latest unicorns update (HT: Marginal Revolution).

10. Interesting announcement by Reliance Industries on its entry into renewables industry with a Rs 75000 Cr investment plan over the next three years,

Under the plan, RIL will set up a Dhirubhai Ambani Green Energy Giga Complex, spanning 5,000 acres, in Jamnagar, Gujarat, at Rs 60,000 crore while another Rs 15,000 crore will be invested in value chains, partnerships, and future technologies, including upstream and downstream industries. RIL will create a capacity of producing solar power of 100 Gw in 10 years. The ambition is stunning as India’s installed capacity of solar power is now 40 Gw (including ground mounted and rooftop)... RIL will set up four giga factories for integrated solar photovoltaic modules, advanced energy storage, an electrolyser factory for green hydrogen, and a fuel cell factory for converting hydrogen into motive and stationary power. For solar manufacturing, RIL will have integrated manufacturing starting from raw silica and poly silicon to ingot, wafers to finished products cells and modules. This will be a major addition to India’s solar manufacturing plans though the company did not reveal the capacity it would be putting up... RIL will focus in a major way on rooftop solar and decentralised solar installations in villages. The second part of the plan entails creating a value chain for the giga factories. It will be part of the Jamnagar complex of the company. RIL’s renewable energy project management and construction division will provide end-to-end solutions for large renewable plants across the world.

To put this in perspective,

India imports close to 90 per cent of its solar cells and module requirements. Eighty per cent of this is from China. According to the industry data, India has 3,100 Mw of cell manufacturing capacity and 9,000 Mw of module manufacturing.

And this pits the two richest men in India in direct competition,

The move will bring RIL into direct competition with the Adani group. Adani Solar has 3.5 Gw of annual solar photovoltaic production capacity while Adani Green Energy has a portfolio of 25 Gw of commissioned and under construction projects.

Whatever finally happens, it says something about Adani Group, that this completely new greenfield announcement by Reliance is more likely to materialise than the Adani Group's plans on green energy. 

11. On a related note, Reliance's financials don't appear too healthy,

The company’s RoCE on consolidated basis declined to 7.8 per cent in financial year 2020-21 (FY21) — the lowest in at least three decades. Similarly, the company’s RoNW declined to a low of 8.4 per cent last fiscal, according to data from Capitaline database. In other words, the company’s returns from its large asset base – the biggest in India Inc – is just a notch above the yield on top-rated corporate bonds. In comparison, Nifty 50 companies reported RoNW of around 14.9 per cent on average in FY21... RIL is also one of the lowest dividend payers among top companies, proportionate to its revenues and balance sheet size. The company paid a total equity dividend of Rs 4,512 crore in FY21. In comparison, Tata Consultancy Services... distributed nearly Rs 30,000 crore among its shareholders by way of dividend and share buybacks last fiscal... The stock is trading at trailing price to earnings multiple of 31X, against Nifty 50 earnings multiple of 29.2X.

12. Pratik Datta has a very educative article which highlights the experience of China with its bad banks. 

In the aftermath of the Asian financial crisis, China set up dedicated bad banks for each of its big four state-owned commercial banks. These bad banks were meant to acquire non-performing loans (NPLs) from those banks and resolve them within 10 years. In 2009, their tenure was extended indefinitely. In 2012, China permitted the establishment of one local bad bank per province. In 2016, two local bad banks were allowed per province. By the end of 2019, the country had 59 local bad banks. Chinese banks can currently transfer NPLs only to the national or local bad banks. Recent research by Ben Charoenwong at the National University of Singapore and others highlights that Chinese bad banks effectively help conceal NPLs. The banks finance over 90 per cent of NPL transactions through direct loans to bad banks or indirect financing vehicles. The bad banks resell over 70 per cent of the NPLs at inflated prices to third parties, who happen to be borrowers of the same banks. The researchers conclude that in the presence of binding financial regulations (for example, on provisioning) and opaque market structures, the bad bank model could create perverse incentives to hide bad loans instead of resolving them.

He also points to the US and Swedish experiences,

The US had set up a bad bank in 1989 — the Resolution Trust Corporation. It had a sunset clause of December 1996. The date was subsequently advanced to December 1995. Similarly, Sweden established Securum in 1993 with an estimated lifespan of 10-15 years. In 1995, Securum’s board proposed that the company be wound up by mid-1997. The parliament finally dissolved Securum in 1997. At the time of its closure, Securum had disposed of 98 per cent of its assets.

He argues for four requirements for India's new bad bank, National Asset Reconstruction Company Limited (NARCL) - finite tenure with a clear sunset; specific narrow mandate with a clear strategy for resolution of bad assets and not mere transfer of those assets; reduce the original banks' exposures to the bad loans (through security receipts) once they are transferred to NARCL; resolution should happen through market mechanism, and arbitrage between ARCs and bad banks should be discouraged. 

13. From an article about how private equity has managed to evade paying taxes. This on how they turned ordinary income into capital gains, twice,

The I.R.S. has long allowed the industry to treat the money it makes from carried interests as capital gains, rather than as ordinary income. For private equity, it is a lucrative distinction. The federal long-term capital gains tax rate is currently 20 percent. The top federal income tax rate is 37 percent... Private equity firms already enjoyed bargain-basement tax rates on their carried interest. Now... they had devised a way to get the same low rate applied to their 2 percent management fees... In a nutshell, private equity firms and other partnerships could waive a portion of their 2 percent management fees and instead receive a greater share of future investment profits. It was a bit of paper shuffling that radically lowered their tax bills without reducing their income. The technique had a name: “fee waiver.” Soon, the biggest private equity firms, including Kohlberg Kravis Roberts, Apollo Global Management and TPG Capital, were embedding fee-waiver arrangements into their partnership agreements... Say a private equity manager was set to receive a $1 million management fee, which would be taxed as ordinary income, now at a 37 percent rate. Under the fee waiver, the manager would instead agree to collect $1 million as a share of future profits, which he would claim was a capital gain subject to the 20 percent tax. He’d still receive the same amount of money, but he’d save $170,000 in taxes...
The whole idea behind the managers’ compensation being taxed at the capital gains rate was that they involved significant risk; these involved almost none. Many of the arrangements even permitted partners to receive their waived fees if their private equity fund lost money. That was the case at Bain Capital, whose tactics a whistle-blower brought to the attention of the I.R.S. in 2012. That year, Bain’s former head Mitt Romney was the Republican nominee for president. Another whistle-blower’s claim described fee waivers used at Apollo — one of the world’s largest buyout firms, with $89 billion in private equity assets — as being “abusive” and a “thinly disguised way of paying the management company its quarterly paycheck.”

And this about how IRS audits of private equity partners and firms have become very rare,

While intensive examinations of large multinational companies are common, the I.R.S. rarely conducts detailed audits of private equity firms, according to current and former agency officials... One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm. That makes the structures notoriously complicated for auditors to untangle. Increasingly, the agency doesn’t bother. People earning less than $25,000 are at least three times more likely to be audited than partnerships, whose income flows overwhelmingly to the richest 1 percent of Americans.

14. It's well known that during the sub-prime crisis, the then Treasury Secretary Hank Paulson was in constant touch with his Goldman successor Lloyd Blankfein and other Wall Street executives. It raised serious concerns about conflicts of interest and ethics. 

Now comes evidence that Steve Mnuchin and Jerome Powell were in constant touch with Larry Fink, the Chief Executive of BlackRock, in the days when the Fed announced several emergency rescue schemes after the pandemic broke out. 

Mr. Mnuchin held 60 recorded calls over the frantic Saturday and Sunday leading up to the Fed’s unveiling on Monday, March 23, of a policy package that included its first-ever program to buy corporate bonds, which were becoming nearly impossible to sell as investors sprinted to convert their holdings to cash. Mr. Mnuchin spoke to Mr. Fink five times that weekend, more than anyone other than the Fed chair, whom he spoke with nine times. Mr. Fink joined Mr. Mnuchin, Mr. Powell and Larry Kudlow, who was the White House National Economic Council director, for a brief call at 7:25 the evening before the Fed’s big announcement, based on Mr. Mnuchin’s calendars... On March 24, 2020, the New York Fed announced that it had again hired BlackRock’s advisory arm, which operates separately from the company’s asset-management business but which Mr. Fink oversees, this time to carry out the Fed’s purchases of commercial mortgage-backed securities and corporate bonds.

The capture of US Treasury by Wall Street is near total. It does not change with administration. As an illustration, now that a Biden administration is in charge, it is fair to imagine it revoking the carried interest loop hole and cracking down on the fee waiver strategies of private equity discussed above. But it's unlikely to happen, even if corporate tax rates go up.   

Wednesday, June 23, 2021

More on why economists make bad plumbers

I've blogged earlier about why economists make bad plumbers. Another exhibit is this interview of Abhijit Banerjee and Esther Duflo. Banerjee says,

I think India is a good example of [a country] where they literally had not thought through their own plumbing. If you think of what happened to the urban migrants, India’s welfare system is actually completely designed on the assumption that people live in their stable families which live in one place for year after year. In your village, you’re entitled to apply for the public distribution, which is essentially nearly free food . . . and in rural areas there is the rural employment guarantee system. Both of those are designed for rural citizens who live in their own village. You’re not entitled to go to any village and say: ‘I want my employment guarantee.’ There might be as many as 50m of these low-income migrants who temporarily live in cities. They can’t connect to the welfare system. That’s why there were pictures in the first lockdown of people walking 1,000 kilometres . . . there was no way for them to survive. They just had to go home. That is pure plumbing failure.

This is pure rhetoric. It's the classic hatchet job - form your hypothesis (a system where migrant workers can access food and other welfare benefits), set up a straw man (the public distribution system, PDS, or any welfare benefit), demonstrate how the straw man fails the hypothesis test (the example of covid induced migration), and blame the system (the government "did not think through their own plumbing" on its programs). Before passing such sweeping judgement on something like the PDS or NREGS, it's useful to understand its original purpose and its trajectory of evolution. It's also classic hindsight-based judgement. 

The PDS, in existence since independence, has the objective of providing food security by distributing foodgrains to the poor living in villages and slums at subsidised rates. Despite its undoubted deficiencies, given its scale and the pervasive state capacity weakness, it's been a remarkable success and is arguably a practical model for food security in any developing country. As I've blogged earlier, along with NREGS, it's been one of the two policy instruments that have ensured India avoided starvation during the pandemic. It has undergone constant improvements over the years, with its effectiveness in terms of inclusion and exclusion errors and service levels being very good in some states. 

But the additional requirement of migrant coverage and describing its absence as a plumbing failure is unfair. Consider the critical requirements for a portable PDS - a portable identity (which allows credible identification of the beneficiary), a dynamic state-wise PDS allocation mechanism (which allows for shifting of PDS allocations across states based on migration trends), a dynamic supply chain (which allows PDS shops to adjust stocks for periodic changes in migration trends), and a country-wide real-time stock management system (that connects all PDS shops). I have overlooked several other factors. The same analysis could be done about employment guarantee schemes. 

Pause and reflect on the enormity of the challenge. Given the context of rural and urban India, a robust and dynamic logistics management of this nature would have been unthinkable till very recently. Now, this is real thinking through the plumbing. How many economists can claim this expertise?

No amount of thinking through the plumbing would have helped overcome these challenges. Each of the four requirements would have been daunting impossible. With advances in digital technologies and Aadhaar, it may now be possible to start pursuing this objective. Recognising this, and even before the migrant crisis, the Government of India had launched the One-Nation-One-Ration Card scheme to make ration cards portable. Portability was even a incentivised as a condition for state governments to access the additional borrowing permitted during covid.

In simple terms, castigating PDS with plumbing failure for non-portability and not covering urban migrants is like judging the batting strike rate of Sunil Gavaskar in comparison to that of the T20-era batsmen. The PDS was designed for a purpose and, on a purely relative terms and in the world of second-bests, it's done a reasonably good job over decades in ensuring food security and eliminating famines from India. Like anything, it has to evolve with time to accommodate the emerging challenge of migrant coverage and more. 

The issue of providing welfare to the 50 million or so migrants in cities with an acceptable enough level of leakages is perhaps one of the hardest targeting challenges in development. Migrants are a floating population, almost exclusively engaged in informal and outside the market activities, with little incentive and a lot of disincentive to being tracked. Therefore, despite the awareness of the problem, tracking them will remain a daunting challenge. In the circumstances, it's the perfect example of armchair analysis to nonchalantly call for transferring cash and other benefits to poor urban migrants. 

It's an altogether different matter that the government (and the vast majority of mainstream opinion makers and researchers) have seriously underestimated the sheer scale of internal migration. It was surely a governance failure that the system was unprepared to deal with the pandemic induced reverse migration. That's not a plumbing failure with PDS or with any specific prevailing government program. But it also needs to be acknowledged that even with the best technologies, targeting migrants with PDS and other welfare services in a reasonably efficient manner will remain elusive for some more time. 

As I have written earlier, instead armchair analysis of areas on which their understanding is limited and grandstanding to reinforce their pet ideas (demonstrating government plumbing failures in development), economists should focus on their research and let the evidence generated inform public debates. Plumbing should be left to plumbers.   

Monday, June 21, 2021

Some thoughts on the individual taxation regime

The recent expose by ProPublica of the IRS filings of some of the richest Americans over the past fifteen years show that several of them paid no or little by way of income tax for multiple years. This despite massive increases in their wealth due to increases in stocks and other assets owned by them. 

At one level, it can argued that the rich are not doing anything illegal and ProPublica is sensationalising the issue by calculating their tax rate on their wealth as against incomes, and their wealth is marked to market and not realised. But this overlooks the reality that the differential treatment accorded to capital gains incentivises the rich to add to their wealth without going through the income route. 

In this context, in a recent NYT oped Anand Giridharadas took on Warren Buffet. I understand Anand to be a polarising figure and Warren Buffet to be the sage of Omaha. But his message is important. Warren Buffet has often argued in favour of higher income taxes, winning acclaim and further adding to his almost messianic image. Therefore, when it emerges that he paid just $23.7 million in income tax over the 2014-18 period even as his wealth soared by $24.3 bn, and he has most certainly engaged in large scale tax avoidance strategies to shift away from taxable incomes towards non-taxable wealth, it's only natural that he invites accusations of hypocrisy. Anand calls it out and uses the striking nature of Buffet's example to make a point,
The important point here is that Mr. Buffett’s tax payments as detailed by ProPublica are fully legal. Though Mr. Buffett has called for changing the tax system, while we have the one we have, he will continue to benefit from the madness of taxing billionaires for their income, rather than their wealth, when their income is pretty much just a number they can construct.
The ProPublic expose does a good job in drawing attention to the issue of low taxes that high net worth individuals pay. But it also highlights the problems with the prevailing taxation regime. There are at least four important aspects that need attention.

One, the major share of the wealth of the richest come in the form of assets and its capital gains, especially financial and property assets. In the circumstances, wealth taxation becomes a matter of priority. In this context, it is worth reminding ourselves that the current prioritisation of income tax and relegation of wealth tax comes from the assumption that people earn incomes (from either wages or capital) whose accumulation in turn leads to wealth. This income path dependency of wealth no longer holds true for the vast majority of today's wealth. 

The ProPublica article has a good graphic that compares the income tax payments and wealth increases of Jeff Bezos and the typical American household.

Whatever the legality of this outcome, its irony cannot be missed. We have a tax regime which clearly  focuses on the wealth generation channels of a bygone era (income channel) and overlooks the main wealth generation channel of our times (capital gains).

Second, most of this wealth is marked to market and therefore capital gains fluctuates with the market conditions. It is a reasonable argument that it can be taxed only when the capital gains are realised. However, this raises the issue of taxing actions which contributes to these capital gains. For example, share buybacks financed by debt, whose interest payments are currently tax deductible, and which in turn raise capital gains, should be discouraged. 

Third, even when realised, capital gains are taxed at a lower rate, with the rates being even lower for longer-term (mostly more than one year) capital gains. Further, why should more than one year be considered long-term? Consider the example of people taxed on share buyback. They (and the company) enjoys two benefits - the interest on loan taken to finance the buyback is tax deductible, and the capital gains is taxed at a lower rate. This distortion, amplified by an ultra-low interest rate environment in the US, has resulted in more money being spent in recent years on debt-financed share buybacks than on investments. 

When dividends are taxed at the marginal rate, there is a strong case that capital gains too be taxed at the marginal rate. The differential taxation of different channels of shareholder income from the same source creates tax arbitrage opportunities and perverse incentives. There is no practically sound justification for the continuation of this differential tax treatment.

Four, while the case for non-taxation of physically unrealised wealth is understandable, it also raises a problem since such wealth, especially in the form of shares, has become an almost perfect substitute for cash (and therefore income) and therefore used for many financial market   transactions. Opaque structures allow capital gains to be exchanged for building ever more capital while avoiding taxes. Howsoever difficult it may be, tax regimes should accordingly explicitly and unambiguously include for taxation of any capital gains financed transactions on the same lines as realised capital gains.   

To the extent that individual taxation is an important means to allow governments to raise resources and deliver public goods, the time has come to re-examine the current mainly income tax based individual taxation regime and replace it with another which also includes the other important source of wealth generation, capital gains. 

Update 1 (26.09.2021)

A new White House study shows that the richest Americans pay significantly low income tax rate than regular tax payers,

The analysis suggests that the wealthiest 400 households in America — those with net worth ranging between $2.1 billion and $160 billion — pay an effective federal income tax rate of just over 8 percent per year on average... The White House’s calculation of what the wealthiest pay in taxes is well below what other analyses have found. The difference comes from the White House officials’ decision to count the rising value of wealthy Americans’ stock portfolios — which is not taxed on an annual basis — as income. It finds that between 2010 and 2018, those top 400 households, when including the rising value of their wealth, earned a combined $1.8 trillion and paid an estimated $149 billion in federal individual income taxes.

The authors of the study point to two types of preferential treatment for certain income in the tax code, 

The federal government taxes income from wages at a higher rate than income from investments, and most wealthy households report a significantly larger share of their income from capital gains and dividends than typical taxpayers do. Mr. Leiserson and Mr. Yagan noted that “the wealthy can choose when their capital gains income appears on their income tax returns and even prevent it from ever appearing.” “If a wealthy investor never sells stock that has increased in value, those investment gains are wiped out for income tax purposes when those assets are passed on to their heirs under a provision known as stepped-up basis,” they wrote. Mr. Biden has proposed changing both those tax treatments. He would raise the capital gains rate to match the rate paid on wage income. And he would eliminate the stepped-up basis provision for wealthy heirs.

Sunday, June 20, 2021

Weekend reading links

1. The overall private capital industry has risen to $7.4 trillion by end of 2020, on the back of investors chasing yields. Of this around $2.5 trillion is dry powder waiting for investment opportunities. 

Industry insiders say that the biggest drivers of the appetite for private capital investments are the low interest rate environment and lofty stock market valuations, which have dimmed the outlook for future returns from those asset classes. At the same time, private markets are less volatile as they trade only rarely and valuations can be more subjective, an opacity that actually increases their lustre to many investors.

2. Tamal Bandopadhyay has some very interesting facts about State Bank of India

State Bank has 470 million customers and 80 per cent of its new customers are in the 20-40 age group. Roughly one out of every three Indians banks with State Bank. It has the largest mutual fund under its belt; boasts of the second largest credit card portfolio; and its life insurance arm is among the largest in the private sector. Has it been using the enormous data base for cross-selling financial products? It doesn’t seem so, if its fee income is any indication. The bank has already put in place the technology platform. When it comes to transactions, 93 per cent happen outside its 22,000-strong branch network. Around 67 per cent of all transactions are digital and one out of five of its customers (90 million) uses internet banking. Its end-to-end digitisation mobile banking and lifestyle app, YONO, has 37 million customers.
3. The strong corporate performance amidst the pandemic has generated intense debate about its causes. One of the causes suggested is that corporates have benefited from lower taxes. An article in HT writes,
However, the fact that income tax collections fell by a much smaller amount than corporation tax collections during 2019-20 and 2020-21 (see chart 1) shows that owners rather than their white-collar workers had a better deal when it came to tax rates.

4.  Many years back I blogged here and here about Kerala being a narrow strip of urban continuum and therefore the value of a high speed rail network running across the length of the state. The State Cabinet has approved a Rs 63940 Cr and 529.45 km long SilverLine high speed rail project connecting Trivandrum to Kasargode in less than 4 hours. If implemented, it has the potential for transformational impact on the state over the next couple of decades. 

5. This was waiting to happen. Citing Covid, the Adani Group has asked for another extension till December 2021 to take over the three airports it won in a tender - Trivandrum, Jaipur, and Guwahati. The bids were finalised in February 2019. The Group had bid very aggressively, quoting Rs 85 and Rs 69 per passenger for Ahmedabad and Jaipur respectively, more than double the next bids of Rs 177 and Rs 174.

Andy Mukherjee has a piece on the Adani Group's recent wobbles in the equity market.

6. Contrasting monetary policy trajectories being charted out by the central banks in Brazil and India. Both countries, like many others, face the twin challenges of rising inflation and struggling economies at a time of monetary accommodation. Persisting with loose monetary policy runs the risk of inflation getting unanchored while tightening would threaten economy recovery. How long can monetary policy remain accommodative without inflation getting out of hand?

The Brazilian central bank has raised rates by 225 basis points this year to 4.25%, betting that inflation is a greater threat and it's better to act early on it. The RBI in contrast has preferred to continue with accommodation despite rising inflation, betting that inflation is likely transient and accommodation is critical to support the economy. The RBI has company among all developed countries. 

7. The Biden administration has displayed remarkable courage and commitment by appointing Lina Khan as the Chair of the Federal Trade Commission, the premier competition regulator. Khan, 32, has been at the forefront of demands for anti-trust actions against the big tech companies and business concentration. As FT reports, this has naturally raised fears among the big technology firms about breaking them up. 

At the heart of Khan’s philosophy is the idea that companies, including Amazon, have benefited from lax antitrust scrutiny for decades, a period during which low consumer prices became the dominant factor in setting competition policy. She envisions a different antitrust regime, similar to that which existed earlier in the 20th century, when US authorities did not hesitate to break up monopolies.

This from her famous essay on Amazon's anti-competitive practices,

This Note argues that the current framework in antitrust—specifically its pegging competition to “consumer welfare,” defined as short-term price effects—is unequipped to capture the architecture of market power in the modern economy. We cannot cognize the potential harms to competition posed by Amazon’s dominance if we measure competition primarily through price and output. Specifically, current doctrine underappreciates the risk of predatory pricing and how integration across distinct business lines may prove anticompetitive. These concerns are heightened in the context of online platforms for two reasons. First, the economics of platform markets create incentives for a company to pursue growth over profits, a strategy that investors have rewarded. Under these conditions, predatory pricing becomes highly rational—even as existing doctrine treats it as irrational and therefore implausible. Second, because online platforms serve as critical intermediaries, integrating across business lines positions these platforms to control the essential infrastructure on which their rivals depend. This dual role also enables a platform to exploit information collected on companies using its services to undermine them as competitors.

8. Amazon and NR Narayana Murthy have been making news for the wrong reasons. The Government of India rules on e-commerce prohibit digital market place operators from being sellers in their own marketplace. But Amazon and Narayana Murthy have found ways around it. This is an example, 

Amazon reportedly developed independent sellers such as Cloudtail, as 'special merchant' which enjoyed over 35 per cent of total sales on the platform until 2019. While NR Narayana Murthy's Catamaran Ventures indirectly holds 76 per cent in Cloudtail and Amazon the remaining 24 per cent, the firm's two top posts - chief executive and finance director - were with the US retailer. Cloudtail's holding company, Prione is also run by a former Amazon manager, the report in 'The Guardian' newspaper said.

And this is how Amazon ploughs back the profits from the 'outsourcing', 

The latest Guardian' report claims... Cloudtail which only sells via the Amazon platform paid Amazon fees of 95 million pounds last year, almost 10 times more than the Indian business reported in profit. According to its analysis, Murthy created the venture capital firm Catamaran, a trustee of the Hober Mallow Trust, which ultimately owns the stake in Cloudtail and whose beneficiaries are the Murthy family. "The whole structure raises questions if Cloudtail is really an asset of Amazon and if the Murthys are the name lenders. The exact detail of the deal will only be known if the investigation agencies seek details of their shareholder agreements, Rashmi Das, an author specialising in Indian e-commerce, is quoted as saying by the newspaper.

Thursday, June 17, 2021

The questionable virtue of lower corporate tax rates

A few days back there was a historic announcement by the G-7 Finance Ministers on globally harmonised rules for taxing multinationals

The detail of the first part of the agreement, a significant US concession by the Biden administration, made it clear that “the largest global companies” with profit margins of at least 10 per cent would, in future have to allocate 20 per cent of their global profits to countries where they make their sales. If implemented this would overturn a century of international corporate taxation, where profits are taxed only where companies have a physical presence...

The definition of the largest global companies is still to be ironed out. This part of the deal will require a global accord later this year. In return for this concession, the US has gained agreement from the rest of the G7 for each country to impose a minimum global corporate tax rate of at least 15 per cent. This will reduce the incentive for large companies to declare profits in tax havens or low tax jurisdictions such as Ireland because the country in which the company is headquartered will be able to top up corporate tax payments to the global minimum effective level. The US is expected to be the largest beneficiary of this second pillar of the deal.

While acknowledging this as a definitive break from the dominant narrative on taxation, especially multinational corporate taxation, Alex Cobham of Tax Justice Network urges caution on excessive optimism. 

But the OECD has narrowed this substantially, and the G7 has narrowed it still further. Now only 100 multinationals are likely to be affected, and only a fraction of their profits above a 10 per cent margin will be apportioned to their sales jurisdiction (with no weighting for the jurisdictions where employment occurs). The OECD estimates this will bring in additional revenues of $5bn to $12bn a year, a 2-5 per cent reduction in the estimated annual losses of $245bn due to profit shifting. The benefits of pillar two are much greater. The OECD estimates that a global minimum tax rate of 12.5 per cent, which would apply to perhaps 8,000 multinationals, could yield nearly $100bn a year in additional revenues. Our estimates show a 15 per cent minimum rate could raise as much $275bn a year. A 21 per cent rate, favoured by the Biden administration, or a 25 per cent rate as recommended by the Independent Commission for the Reform of International Corporate Taxation, would raise far more.
He writes about how the current proposal favours developed over developing countries,
The OECD approach privileges headquarter countries. This means that if a French multinational shifts profits out of Brazil to benefit from Bermuda’s 0 per cent tax rate, it would be France that could “top up” the taxes on that profit to 15 per cent. As most of the largest multinationals are headquartered in OECD countries, the majority of the benefits would go to them. G7 members, with 10 per cent of the world’s population, stand to receive more than 60 per cent of the additional revenues. The alternative proposed by the Tax Justice Network, the Minimum Effective Tax Rate (METR), would allocate undertaxed profits according to the location of the multinationals’ real activities. They would be taxed at the national headline rate, rather than at the agreed global minimum, to avoid incentivising profit shifting. A 15 per cent rate would raise as much as $460bn in additional revenues. For major G20 members outside the G7, the difference is stark. At a rate of 15 per cent, India could gain $13bn rather than $4bn; and China $72bn rather than $32bn. Additional revenues would double or even triple for countries such as Brazil and South Africa.
Whatever the details of the announcements, this, coupled with the Biden administration's corporate tax increase plans, marks a definitive shift in the global trend towards lowering of corporate tax rates. In the coming years, there is an eminently justifiable window available for developing countries to push the agenda further on pillar one and entrench the principle of corporate taxation of multinational corporations towards the location of their business activity.

This brings us to the larger issue of domestic corporate tax rates, whose reduction is a constant demand among opinion makers everywhere. A few observations on the same.

Notwithstanding the theoretical Econ 101 models, I have not seen any recent evidence for reducing corporate tax rates below what have been prevailing rates in developing countries for a few years now. I am inclined to believe that reducing corporate tax rates has become a self-serving evidence-free narrative that businesses and their supporters have constructed to put pressure on governments. 

At a conceptual level, there are at least two factors to be considered. One, one does not know which side of the so-called Laffer curve is the marginal rate, and if reduction of rate will actually increase revenues. Second, the link between lower rates and higher investments is deeply questionable. There is little evidence on both, given the current circumstances. 

On this Rana Faroohar points to a new paper by McKinsey which examines trends in the economy over the past quarter century. This graphic is stunning and questions the conventional wisdom on corporate revenues translating into tax incomes and investments. Note than investments are negative everywhere except Japan, which in many respects does not follow the US-style capitalism. In fact, the value flow from revenue increment gets disproportionately allocated towards capital income.

Most countries have experimented with corporate tax rate reductions in recent years on the back of pressures from global and domestic "reform" constituencies. Consider India's series of reforms,

In 2016-17, new manufacturing companies incorporated on or after March 2016 were given the option to be taxed at 25 per cent plus surcharge and cess (compared to 30 per cent plus surcharge, etc.) if they did not claim profit-linked or investment-linked deductions, investment allowances, or accelerated depreciation. Additionally, the tax rate for all companies with an annual turnover of less than Rs 5 crore was brought down to 29 per cent plus surcharge and cess. In 2017-18, the tax rate for small and medium companies with an annual turnover of up to Rs 50 crore was brought down to 25 per cent. This meant about 96 per cent of companies that filed a tax return were brought under a concessional tax rate of 25 per cent plus surcharge and cess... In the following year, 2018-19, the government extended the coverage of the 25 per cent tax rate to cover all companies with an annual turnover of up to Rs 250 crore — a move that would benefit 99 per cent of companies filing tax returns and deprive the government of an additional annual tax revenue of Rs 7,000 crore...

In 2019-20, the government extended the concessional tax rate of 25 per cent to all companies with an annual turnover up to Rs 400 crore, thereby covering 99.3 per cent of all companies filing tax returns. Subsequently, in September 2019, all companies not availing themselves of the various exemptions and incentives like tax holidays were allowed to be taxed at 25 per cent, inclusive of the 10 per cent surcharge and a 4 per cent cess. Moreover, manufacturing companies starting operations after October 1, 2019, were to be taxed at an overall rate of 17 per cent.

This is an impressive set of reforms in following the principles of Econ 101. And if the narrative and opinion makers were correct, there should have been greater investments and higher revenues, at least some signs. But the reality has been very different. Consider this balance sheet of India's corporate tax rate reduction,

The corporation tax collections in 2020-21 were around 17.9% lower than in 2019-20, when they had stood at ₹5.57 trillion. In comparison, income tax collections fell by just 2.3% between 2019-20 and 2020-21. They had stood at ₹4.80 trillion in 2019-20... In September 2019, the Centre cut the base corporation tax rate to 22% from the earlier 30% and 15% from the earlier 25% for new manufacturing companies... the investment-to-GDP ratio in 2020-21 falling to a two-decade low of 27.1%. It was at 28.8% in 2019-20. The ratio has largely been falling since peaking in 2007-08 at 35.8%. Hence, we have a peculiar situation where listed corporations have made their highest profits ever, and the corporation tax collections have declined. The extent of the fall can be gauged from the fact that corporation tax collections in 2020-21 were almost similar to that in 2015-16 when they were at ₹4.53 trillion.

Obviously, since there are too many things going on it's too early to pass a verdict on India's corporate tax reduction of 2019. However if we take the series of rate cuts over the last six years as a whole and compare with trends on investments and total revenues, there is at least some argument in favour of the case against corporate tax rate reductions. In any case, beyond the entrenched narrative on tax reduction, there was no evidence to back the case for lowering corporate taxes in India in 2019. Further, effective tax rates in many industries were extremely low given the large numbers of exemptions.  

The argument about lowering marginal tax rates while also removing exemptions, though theoretically great, bears great similarity to that about lowering tariffs and also redistribution from winners to losers. In case of trade, as we have seen over decades, while the former has been happening, the latter is too politically fraught and with entrenched lobbies as to materialise. On the same lines, while lowering marginal tax rates happens at the stroke of a pen, the latter, even when announced, gets entangled in the deep thickets of political economy and vested interests. Even a cursory glance at the long list of exemptions in the Receipts Budget 2021-22 will reveal the scale of this challenge.

Further, the belief that tax exemptions can be eliminated with administrative diktats underestimates the power of the tax avoidance industry. Given the opaque corporate shareholding structures, complexity of tax rules, weak state capacity, open economies, globalised supply chains, multinational corporations etc, and the army of tax avoidance experts that large corporates employ, it's fair to argue that corporate tax avoidance strategies will always remain far ahead of tax regulations.

The net result will be that ultimately corporates will get their lower marginal taxes and also get to keep the exemptions! Heads I win, tails you lose!

More fundamentally, much of the evidence on the beneficial effects of lower corporate tax rates date back to an era of very high marginal tax rates, like this from 2004. However, since then there has been a secular decline in corporate tax rates across the world and we may have reached a point where it may have become welfare decreasing. There is realisation of this even in the developed countries as evidenced by the decisions to raise corporate taxes in US. 

In many respects, this is similar to the trends with tariff reductions in global trade. As Dani Rodrik and others have shown, tariffs have reached a state where further reductions in tariffs generate negative returns. It is one thing to liberalise when tariffs are very high and an altogether different thing to continue doing so when tariffs have fallen to reasonable or low levels. We appear to be at this moment in corporate taxes too. The narrative endures despite the declining rates over the years.  

Finally, there is another striking thing about the demands for tax reduction, either corporate or income tax reduction or lowering the slab for income tax. It has become the unquestioned narrative that reducing taxes are in general good for the economy, despite little relevant evidence to this effect and the fact that this claim is being made by those who stand to benefit financially from the reduction. In case of corporate taxes, most often the argument just boils down to cross-country competitiveness, as if it depended overwhelmingly on tax rates. All this raises several questions. 

What were the marginal and effective tax rates of the developed countries in their growing phases or E Asian economies in their high growth years? How do those rates compare with that of India over the last two decades? How did their respective rates compare then with those of their developed country competitors? What does the stage of development evidence about corporate tax rates inform us? Are corporate tax rates, especially for a large economy like India, to be determined mainly on a prevailing cross-country comparative basis? Most importantly, what's the evidence that lowering of corporate tax rate, given the prevailing baseline, leads to greater investments?

It's time for evidence-based arguments on corporate taxes to replace narrative based ones. 

Wednesday, June 16, 2021

Financial liberalisation with Chinese characteristics

In his excellent book on China's industrial policy Barry Noughton describes how Industrial Guidance Funds have become a massive and important lever of government's economic engagement. 

Industrial Guidance Funds (IGF) took off after 2014. They grew rapidly through the end of 2018, and by June 30, 2020, the total designated fund-raising scope of all these funds was an astonishing 11,275 billion RMB —that is, 11.27 trillion RMB, or roughly USD $1.6 trillion.

In that context, The Economist has an article which describes the remarkable world of public private equity (or government guided funds) in China,

More than 1,000 government-guided funds have cropped up across China since 2015. By late 2020 they managed some 9.4trn yuan, according to China Venture, a research firm. A national fund focused on upgrading manufacturing technology held 147bn yuan at the last count. One specialising in microchips exceeded 200bn yuan in 2019. Almost every city of note across China operates its own fund. A municipal fund in Shenzhen says it has more than 400bn yuan in assets under management, making it the largest city-level manager of its kind. In the northern city of Tianjin, the Haihe River Industry Fund is putting to work 100bn yuan along with another 400bn yuan from other investors... Owing to a lack of in-house investment talent, most of them have acted as limited partners (LPs) in private-sector funds... As a result, PE in China is now flush with state financing. In 2015 private-sector money made up at least 70% of limited-partner funds pouring into the industry. By the end of 2019, state-backed funds accounted for at least that much. Their dominance has only increased since then; by some counts they hold more than 90% of the money in Chinese funds of funds (ie, those that invest in other funds).

This about competition,

With smaller funds dying off over the past few years—either owing to lack of capital or huge losses—competition for target assets has eased a little. The market is healthier, investors say, as private and state capital is channelled to better fund managers.

And the inevitable overlap of all this with the Communist Party, 

Shenzhen Capital, a huge state fund, posted pictures on its website of a meeting it held in December where it helped each of the 42 companies it had invested in to launch a Communist Party committee. These are seen as a way to imbue private companies with party ideology.

Even with all its distortions, this is another example of how China has managed its financial liberalisation in its own unique way. Three things stand out. 

1. As Barry Noughton has described, there is a clear industrial policy direction about the specific areas targeted by these funds, the strategic emerging industries (SEI) and Innovation Driven Development Strategy (IDDS). 

2. There is also the disciplining force of competition which operates at multiple levels. Apart from the business competition among the large numbers of funds, there is also the competition among the party leaders of the government entity to demonstrate success. 

3. Finally, the scale at which these things are being done (more than $1 trillion in such guided funds) is critical to the likelihood of success of this approach. For example, it provides enough slack for failures and distortions.