Foreign investors ask for too much (and we oblige most of the times)..

Prof. Ashima Goyal of IGIDR has a timely piece on FII-MAT issue:

The fall in Indian equity prices should not be interpreted as a fallout of the tax administration’s decision to impose minimum alternate taxation (MAT) on foreign portfolio investors. Much of the foreign portfolio outflows are influenced by global factors such as fragility in bond markets and a rebalancing towards Chinese equity, which has risen sharply due to Chinese monetary stimulus.

That said, the MAT issue has had a strong effect on perceptions. This is despite the policy message aiming to make the system more predictable and user friendly, and the announcement that MAT would henceforth not apply to foreign portfolio investors (FPIs). Greater clarity should actually lead to more inflows. Savvy investors should be taking advantage of the correction.

A valid grievance is the delayed imposition of the tax, after FPIs had settled their accounts. It has reinforced the reputation of an administration out to squeeze as much revenue as possible.  But the quasi-judicial bodies that took the decision to levy MAT were created partly to make the tax system free of political interference.

There are legal remedies, since rulings can be contested in the upper courts. Even so, the message of a friendly tax administration needs to be clearly understood at all levels of the tax hierarchy, with restructuring to reduce multiple centres of power and discretion. Junior officers have too much power to make arbitrary demands as part of chasing tax targets.

India needs to develop its capital markets, and the country has opened up to foreign investors partly for that purpose. It has to honour its contract with them, but tax concessions given at a development stage cannot last for ever.

Harsh words like tax terrorism etc were used in this case.

Keeping this tax issue aside, it is alarmingly getting clearer how opening up to foreign investors leads to erosion of sovereignty. The govt has been helpless ever since the issue has broken out and was required to give number of clarifications. Compare this to several hapless citizens who are made to to several rounds of tax authorities for all kinds of taxes. They have no voice whatsoever. But FII’s collect together and threaten markets leading to genuflection of the govt.

Rodrik’s trilemma is kicking big time.

Sometimes simple and bold ideas help us see more clearly a complex reality that requires nuanced approaches.  I have an “impossibility theorem” for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full.

Here is what the theorem looks like in a picture:


To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.

So what do we do?

One option is to go for global federalism, where we align the scope of (democratic) politics with the scope of global markets. Realistically, though, this is something that cannot be done at a global scale. It is pretty difficult to achieve even among a relatively like-minded and similar countries, as the experience of the EU demonstrates.

Another option is maintain the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives. The nineteenth century gold standard provides a historical example of this kind of a state. The collapse of the Argentine convertibility experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with democracy.

Finally, we can downgrade our ambitions with respect to how much international economic integration we can (or should) achieve. So we go for a limited version of globalization, which is what the post-war Bretton Woods regime was about (with its capital controls and limited trade liberalization). It has unfortunately become a victim of its own success. We have forgotten the compromise embedded in that system, and which was the source of its success.

So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man’s land.   

As govt has clearly indicated, economic integration will only rise with full capital account convertibility (and what not) expected in few years. This means we either do away with nation state or democracy. Democracy is pretty deep rooted here and likely to remain localised. It is nation state and sovereignty which stands to be compromised as it responds only to the needs of the global economy. This despite the fact that how badly global economy actors have behaved over the recent years.


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