Current Affairs: Economy - Major Issues 25 Aug to 25 Sept 2010

CAG Weekly
(Current Affairs & GK)
By Om Prakash (Goldy sir)

Celebrations cut short, extra 1% EPF interest to be taxed

• The government’s surprise gift for workers isn’t much of a gift after all. The labour ministry has hiked the employees’ provident fund, or EPF, rate to 9.5%, but a finance ministry notification says that anything in excess of 8.5% will be taxed.  This is because, even before the EPF board met to declare the higher rate, the CBDT (Central Board of Direct Taxes) had notified a tax-free PF rate of 8.5% for 2010-11 -- effectie from September, 1.  This means that the 9.5% provident fund return would be tax-free from April to August, but taxable thereafter.
• This is an unprecedented situation that is witnessed.  Historically, the tax-free PF rate notified by the income tax department has never been lower than the EPF rate declared for the year.
• Implementing tax deduction by the EPFO and the company-run trusts is sure to pose lot of problems.  For instances they will find it hard to calculate the tax liability on 1% PF income for seven months, as they don't have the appropriate systems in place to do so.
• The labour ministry is, however, confident that the tax department will renotify the higher rate, as otherwise a lot of contentious issues will come up.
• EPFO's hidden treasure enables it to declare 9.5% return
• The government brought cheer to five crore employees in the organised sector ahead of the festive season by announcing a one-percentage point increase in the interest rate on provident fund savings for 2010-11, along with a host of reform measures to make the scheme more subscriber-friendly.
• The Centre will notify the 9.5% rate after consultations with the finance ministry. The EPF rate has been languishing at 8.5% for the last five years. The higher rate of 9.5% became possible after the Employees’ Provident Fund Organisation (EPFO) discovered a hidden surplus of 1,731.57 crore in its accounts.
• The Manmohan Singh government had last paid 9.5% interest on PF balances in 2004-05.
• The EPFO board also decided to stop paying interest to accounts that have not seen any fresh contribution for three years or more. This will help the organisation put a lid on nearly 3 crore inoperative accounts, helping it save administrative costs and improve efficiency.
• It also hiked the benefits on the employees’ insurance scheme, linking it to the wages at the time of death subject to a maximum of 130,000. Currently, the ceiling on insurance benefits under the Employees’ Deposit-Linked Insurance Scheme is 1 lakh. EPFO reworked math after realising error

Big role, big profit for states in shale gas policy

• The government is reportedly finalising a new policy for exploring shale gas that will provide states a share of the profit booty that exploration companies give as profit petroleum to the Centre.
• Profit petroleum is a part of the revenue earned by the exploration company when it sells oil or gas. Proposed to be called shale gas payment as opposed to profit petroleum, this revenue will be shared between the centre and the state.
• This new policy is being scripted to get proactive support from state governments in this new field of energy that is set to be a game changer. The profit share will be over and above the royalty that state government would earn from the oil company.
• It would be essential to get the state governments as a partner in the development of shale gas as this new unconventional gas involves exploration over large areas.
• The profit share for the state would incentivise states to help with the land acquisition as it is under the direct jurisdiction of the state governments. It is expected that the resource rich states would invest these revenues in the development of the region to avoid conflicts with local populace such as agitation against bauxite mining in Niyamgiri.    
• Shale gas is non-conventional natural gas found in non-porous rock and requires fracking technology to extract gas from shale. Global majors like Exxon, Chesapeake, Davon and Pioneer are the market leaders in shale gas.
• Fracking technology involves sending fluids down the well at ultra-high pressure to help oil flow in from rock formations.
• Bumper food crop expected
• The farm ministry’s first advance crop estimates for this kharif have projected a bumper output, which should help cool food inflation running at over 15%.
• Good rainfall across the country, barring a few states in the east, has led to a sharp increase in cropping that is expected to yield a substantially higher production of nearly all food items.
• The production of rice is projected to go up 6% to 80.4 million tonne while output of pulses is expected to rise 33% to six million tonne.
• Sugarcane production growth has also been pegged at 17%, spurring hopes of lower sugar prices.
• The country has so far received 4% more rainfall than the long-term average and the good soil moisture is expected to help the rabi crop as well. The planning commission expects the farm sector to grow 5-6% in the current year.

A bit about the new rules that SEBI has laid down for foreign funds

• SEBI's new rules that will be kicking in from October 1, 2010 stipulate that FIIs and their sub-accounts have to ensure that the money they manage is raised from several offshore investors and not from a single or a few investors.
• The rule is aimed at curbing round tripping of money by rich Indians and NRIs who often use FIIs to play the Indian stock market.
• According to market circles and custodian sources, more than 500 sub-accounts have come under pressure.
• Under a broadbased structure, each sub-account must have at least 20 investors, and no investor can contribute more than 49% of the pool, unless there are institutional investors like pension funds, in which case the number can be less than 20. But, for years, several sub-accounts have been functioning as multi-class entities where each registered sub-account runs mutiple cells pursuing different investment strategies. There have been regulatory concerns that once a multi-class share entity is registered, it can add new cells that can be used for round tripping.
• Over the past one month, Sebi has also issued letters to FIIs and sub-accounts, reminding them to shut protected cell companies (PCC), which are similar to cells in a multi-class entity. They have been told that as PCCs, they cannot buy fresh securities. Under the circumstances, PCCs will have to reapply as new entities and may be forced to liquidate their investments if Sebi rejects their registration.
• Sebi, which felt that PCCs and multi-class structures not only went against the spirit of FII regulations but were ways to side-step rules, came out with the new directions in April, giving foreign investors six months to comply. But the latter need more time.
• There are about 1,732 FIIs and 5,553 sub-accounts registered with Sebi.
• According to a senior stock broker, the demise of multi-class entities and PCCs will drive offshore investors to buy participatory notes—instruments that allow offshore investors to trade in Indian shares.

Government grapples with changes to the mining policy

• The government is determined to implement a policy intended to give those displaced by mining a share in the profits of the miners.
• The policy, part of a legislation setting the rules for investment in mining, will also apply to captive mines of companies such as Tata Steel, SAIL and Hindalco. The bill, if approved by Parliament, could make it mandatory for companies to issue equity shares to each member of every family displaced by the project as well as 26% of the profit, according to a draft version of the bill.
• The government's thinking is that if affected persons share profits arising from mining operations, resistance from the local population whose land has to be acquired for industrial projects would dwindle.
• The current government regulations permit 100% foreign direct investment, or FDI, in most mining activities under the automatic route. Despite this, the actual FDI flows have been a measly $150-200 million. This has not deterred the government from setting the ambitious target of increasing FDI in the sector to over $20 billion in the next few years.

What should we do to handle another financial crisis?

• First, further strengthen the banking and financial system by capitalising it even higher than the new Basel III requirements. A hybrid equity layer, which can be converted into equity at the RBI’s direction, should be introduced.
• Second, annual stress testing of all banks on the lines of the tests recently conducted by the Fed and European Central Bank. The rating agencies are well-equipped to conduct these tests, but the basic parameters/scenarios should be uniform and specified by the RBI every year.
• Third, a more dynamic credit policy framework by the RBI and more importantly, by individual banks, such that credit is tightened quickly (and other measures introduced swiftly) when there are signs of excesses in any section of the economy. Most importantly, if property or stock prices are rising too fast.
• Four, counter-cyclical provisioning policy by banks. The RBI is already encouraging this but should consider taking loan loss provisions to 100% (from 70%) level in the next three years. This provision could be relaxed during the downturn to revive the economy quickly.
• Five, encouraging long-term capital flows such as FDI in plant & machinery, venture capital, growth capital and discouraging short-term or hot money capital inflows. A further restriction on short-term capital flows should be considered. This will help reduce the contagion impact.
• Six, a well-capitalised subsidiary structure for foreign banks and financial institutions operating in India in such a way that if the parent institution runs into trouble, the Indian entity is not directly impacted.
• Seven, we should enforce the Volker Rule i.e., strict limits on bank’s proprietary trading and alternate asset activities, even though the rule got compromised in the Dodd-Frank Act in the US.
• Eight, a single consumer protection agency should be created to cover all financial products from banks loans/deposits, stocks and bonds, mutual funds, insurance, etc. This agency should focus on: financial literacy promotion, ensure that financial products are appropriately designed and marketed transparently to consumers with different levels of risk capacity, and grievance redressal. At present, these functions are fragmented among different regulators in India. The Dodd-Frank Act includes a very good model for this.
• Nine, executive compensation in the financial sector should be moderated. The RBI has already made a good start, but more emphasis on compensation linked to long-term performance is needed in all areas of financial services.
• Finally, private sector should facilitate creation of an independent and unofficial economic stability think-tank composed of experienced economists, bankers and academics that should monitor the Indian and global economy to identify excesses, overheating, emerging risks, etc, and share its independent views with the country’s economic decision-makers.
• What are the Basel-III norms?
• These are rules written by the Bank of International Settlement’s Committee on Banking Supervision (BCBS) whose mandate is to define the reform agenda for the global banking community as a whole. The new rule prescribes how to assess risks, and how much capital to set aside for banks in keeping with their risk profile.

Wholesale Price Index: new series comes into being

• Consumer items widely used by the middle class like ice-cream, mineral water, flowers, microwave oven, washing machine, gold and silver will be reflected in the new series of WPI inflation to be released on Tuesday.
• The new series of Wholesale Price Index (WPI) for with additional 241 items and change in the base year from 1993-94 to 2004-05 will be released .
• With these items, the WPI will measure a total of 676 items against the existing 435. “This would give better picture of the price variation,” a senior official said.
• Readymade food, computer stationery, refrigerators, dish antenna, VCD, crude petroleum and computers would also be part of the new series.
• Under the primary article group of the new WPI, there would be 102 items against the existing 98 while the fuel and power category would remain static at 19.
• There is a substantial increase in the number of items in manufactured products. In the new series, there would be 555 items compared to 318 items at the moment, according to the official.
• At the same time, the weight of manufactured products would go up to 64.9 per cent compared to 63.7 per cent while the weight of primary articles group, including food, has come down to 20.1 per cent against existing 22.02 per cent. The data release would accompany inflation numbers with old base year (1993-94) as well for comparison, the official said.
• The new series of WPI is based on the recommendations of the Working Group headed by Planning Commission member Abhijit Sen.
• Service Price Index-The official said the government was also working on Service Price Index which would measures the variation in prices of services providers.

A pragmatic approach

• The decision to defer the implementation of the Direct Taxes Code (DTC) by a year to April 1, 2012 is based on pragmatic considerations. The government will have more time to gauge the revenue implications of the changes in tax laws and procedures. Initial reports suggest that if the DTC bill, now before a parliamentary select committee, is implemented without substantial modifications, the Central government may have to forgo over Rs.50,000 crore in the first year.
• That would clearly be unacceptable, given the large fiscal and budgetary deficits the government is trying to rein in. The extended deadline gives businessmen and investors more time to evaluate the cost and implications of doing business under the new tax regime.
• As with the Goods and Services Tax (GST), which seeks to overhaul the indirect tax structure, the government is adopting a flexible approach to the DTC also.
• The draft code first released in August 2009 was substantially revised in June this year, incorporating the feedback and suggestions including from professional and business bodies.
• The bill is based substantially on the June draft and, although it is still open for scrutiny and modifications, what emerges is likely to fall somewhat short of the original objective of ushering in a simplified tax system with low rates and minimal exemptions.
• Individual tax payers have reason to be both satisfied and disappointed over specific provisions of the DTC bill. There has been no reduction in the tax rates, only a tinkering with the tax slabs benefiting certain categories.
• There has been no rush to embrace the EET method (exempt savings, exempt interest on savings, but tax withdrawals) that would have radically altered the tax treatment of retirement benefits to the detriment of senior citizens and pensioners.
• Tax deductions for contributions to provident funds and certain other eligible schemes remain, and the overall limit has been enhanced. Home loan borrowers will be disappointed as only the interest payment on the loan will qualify for deductions. Both Indian and foreign companies will be taxed at a flat rate of 30 per cent, which is lower than the current effective rates for both categories.
• The bill has introduced greater clarity in the tax treatment applicable to the purchase and sale of securities. As with mature economies, the share of direct taxes in total tax collections will go up and the proportion of overall tax in GDP will climb to around 25 per cent. While the compromises make the bill in its present form much less radical than the original proposals, it will still be a major step forward in simplifying the law and streamlining procedures.