## cr18255

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---

### GST Incidence Under Current Structure — key findings
- The GST was introduced on July 1, 2017, subsuming central excises, state VATs, central service tax, countervailing and additional duties, and numerous levies, and bringing services into the state tax net.
- Multiple non-zero GST rates: 5 percent, 12 percent, 18 percent, and 28 percent; special low rates of 3 percent on gems and jewelry and 0.25 percent on rough diamonds; and a GST “cess” on demerit goods.
- Among 115 countries with VATs, 49 have a single rate and 28 have two rates; India is in a small group of five countries having four or more GST rates.
- Compliance and administrative costs can rise with legislative complexity, procedural requirements, clientele characteristics, and verification costs under high informality.
- Evidence and estimates:
  - Overall tax compliance costs can range between 2–10 percent of revenue yields, and be as high as 2½ percent of GDP (Barbone et al. (2012)).
  - For large Indian firms, anecdotal evidence suggests GST-related compliance costs increased to 0.2 percent of total costs (excluding switch-over costs of about the same level).
  - Compliance costs are generally regressive.

### GST incidence empirical results (January 2018, NSS-based)
- Estimated average effective GST rates by household consumption quintile under the current GST rate structure:
  - Lowest quintile: 9.0 percent
  - Fourth quintile: 9.6 percent
  - Topmost quintile: 10.5 percent
- Indirect incidence due to exemptions (embedded input-tax costs) is regressive:
  - Lowest quintile: additional 2.5 percent effective GST rate from indirect incidence.
  - Highest quintile: indirect incidence of 1.7 percent.
- Conclusion: direct incidence from GST design is progressive; exemptions produce regressive indirect effects that partially erode progressivity.

### Simulated rate-structure scenarios and outcomes
- Single (flat) rate simulation:
  - Flat 10 percent GST rate (with current exemptions) yields about the same aggregate GST revenue on the given consumption profile.
  - Under flat 10 percent, total incidence becomes 10 percent for all quintiles.
  - The flat 10 percent simulation raises 99.4% of the revenue raised under the current GST structure.
  - Effect: effective GST rises significantly for lower quintiles and falls for the highest quintile.
- Dual-rate simulation:
  - Revenue-neutral combination: 9 percent standard rate and 25 percent high rate (applied to items currently taxed at 28 percent), retaining current exemptions.
  - Resulting total GST incidence by quintile:
    - Lowest quintile: 9.6 percent
    - Highest quintile: 10.1 percent
  - The dual-rate simulation raises 99.6% of the revenue raised under the current GST structure.
  - Effect: modestly progressive incidence; lower standard rate reduces burden on poorer households relative to a single 10 percent rate.
- Potential adjustments to improve progressivity:
  - Apply the higher rate more selectively to exclude consumption patterns of poorer households.
  - Adjust the top rate higher if needed.
  - Eliminate exemptions to remove regressive indirect incidence from uncredited input taxes.

### Caveats, distributional and administrative considerations
- Data quality and under-reporting:
  - Analysis uses NSS Household Consumption Expenditure data; systematic under-reporting of high-value items would understate progressivity under the current GST.
  - Even allowing for under-reporting, a dual rate would likely remain progressive relative to the current structure.
- Impact on small businesses:
  - Concern: a uniform rate could increase effective GST payable by small firms, potentially causing exit and adverse employment/output effects.
  - Counterpoint: resources freed by exiting firms would likely be absorbed by firms able to grow and operate under a uniform tax regime.
- Treatment of firms outside the GST net and threshold rules:
  - Registration threshold: annual turnover threshold INR 2 million or US$29,400.
  - Firms with turnover between INR 2 million and INR 15 million (US$ 220,500) pay a flat 1 percent tax, cannot charge GST on sales, and cannot avail input tax credits.
  - Scale of firms (2016 Economic Census of India):
    - 58.5 million establishments in operation;
    - 45.4 million in non-agriculture (including public sector);
    - 10.4 million firms registered under GST, of which 1.3 million are under the “composition scheme”.
- Two illustrative cases for exempt firms’ input profiles and implications:
  - Case 1: Exempt firms purchase inputs and pay GST on them (cannot claim credits). Embedded tax costs add to indirect incidence; if exempt firms predominantly supply poorer households, GST is less progressive than estimated.
  - Case 2: Exempt firms have zero or minimal purchased inputs. Then current GST incidence would be lower than estimated in Section B; incidence under flat/dual rate scenarios depends on how exempt firm shares change.

### Key trade-offs and policy implications (GST)
- Fewer rates and fewer exemptions reduce compliance and administrative costs and opportunities for rate-shopping or lobbying.
- Equity trade-offs: a uniform rate can be less progressive unless offset by:
  - A dual-rate design with a lower standard rate plus a high rate on select items,
  - More targeted application of high rates,
  - Elimination or reduction of exemptions that generate regressive indirect incidence.
- The dual-rate option (9 percent + 25 percent top rate) can preserve modest progressivity and retain near-revenue neutrality while lowering compliance complexity relative to the existing multiple-rate system.
- Simplifying the GST is possible without imposing a significantly higher burden on the poor:
  - A dual rate structure with a low standard rate (and high rate on high-value consumption items) would still allow for progressivity.
  - Rationalizing exemptions by eliminating regressive indirect incidence from unrefunded input tax costs would preserve progressivity.
  - Benefits: lower costs of compliance and administration; reduced incentives to lobby for lower rates.
- Data and methodology notes:
  - Household consumption data: NSS 66th Round Consumption Expenditure Survey (2011–12), >100,000 households, nearly 350 goods and services.
  - Indirect incidence estimated using Input-Output Tables of the Indian Economy 2007/08 and Leontieff-inverse coefficients.
  - Revenue-neutral scenarios applied to the same household consumption data and mapped to GST items.

### Policy recommendations (GST)
- Consider a dual-rate GST with a low standard rate and a selective high rate on luxury/high-value items to maintain progressivity while simplifying rates.
- Rationalize and reduce exemptions to remove regressive embedded input-tax costs.
- Strengthen data collection and monitoring to better assess incidence and under-reporting.
- Weigh small-firm impacts when moving to uniform rates; consider transitional or compensatory measures for genuinely vulnerable small firms.

---

### Fiscal discipline in Indian states — recent trends and context
- States’ finances have deteriorated in recent years; states are a key determinant of general government public finances.
- Adoption of 3 percent of GDP fiscal deficit limit in early-to-mid 2000s helped improve fiscal positions: aggregate deficits of states declined from above 4 percent of GDP to 2 percent of GDP by FY2010/11.
- Since FY2010/11, deficits of states have been on a rising trajectory, though states have largely adhered to the 3 percent of GDP deficit limit.
- States’ share of the general government deficit increased from 23 to 43 percent, as their expenditure share rose by about 10 percentage points and their revenue share by around 4 percentage points.
- General government debt hovering around the 70 percent of GDP mark and the states’ share estimated at just over 25 percent of GDP (FY2017/18 budget estimates).
- About 140 basis points of increase in state debt to GDP over the last 2 years explained by broad subscription by states to the UDAY scheme (states took over the debt of state electricity distribution companies).

### Market borrowing, perceived guarantees, and empirical evidence
- States’ market liabilities rose from less than a fifth of outstanding liabilities in 1992 to more than half in FY2016/17.
- Perception of implicit central guarantees persists for most state market and external borrowings; RBI interventions (stop-payments, first claim over revenues) contribute to this perception.
- Econometric evidence:
  - Model: SDL yield minus ten-year central government bond yield.
  - State fundamentals vary widely:
    - Interquartile range for state real growth: 3 percent to 17 percent.
    - State deficit-to-GDP: 4 percent to 13 percent.
    - State debt-to-GDP: 18 percent to 35 percent.
  - Range in spreads at most 100 basis points; tighter for non-special category states.
  - State fiscal fundamentals explain only 5 percent of variation in spreads.
  - Adding liquidity conditions and global returns raises explanatory power to 70 percent; both significant at the 1 percent level.
  - Results robust to controls (political alignment, fiscal rules, reliance on transfers) and exclusion of special category states.

### International comparative evidence
- Advanced-economy studies find SNG spreads respond to fiscal fundamentals in the United States, Canada, Germany, Australia, and Switzerland.
- Fiscal institutions (expenditure/debt/revenue rules) interact with fundamentals to affect spreads (examples: U.S., Euro Area, Switzerland).

### Strengthening market discipline in India — recommended conditions and reforms
- Four enabling conditions for market discipline (Lane (1993); Ter-Minassian (2007)):
  - Free and open financial markets:
    - Recommendation: continue to lower the statutory liquidity ratio (SLR) to liberalize markets and improve bond-market liquidity (FSAP 2017 noted).
  - Timely and adequate SNG data:
    - Recommendation: improve quality, coverage, and timeliness of state-fiscal data; current publication lags and limited coverage of wider state public sector are shortcomings.
  - Flexibility to respond to market signals:
    - Note: Adoption of the GST reduced states’ ability to set indirect tax rates independently; a buoyant GST could relieve revenue constraints.
  - Strengthening no-bailout expectations:
    - Recommendation: adopt explicit bailout frameworks with bail-in features or stringent sanctions to make fiscal imprudence costly and incentivize creditor discrimination across states.
    - Examples cited: Spain’s ex-post bailout framework; Korea’s early warning system and central intervention tools.
    - Alternative: insolvency framework involving debt restructuring and asset sales (less relevant for India).

### Practical RBI and market measures to increase yield differentiation
- RBI measures to support SDL differentiation and liquidity:
  - Shift to weekly from fortnightly auctions (October 2017) to even out issuance sizes and increase SDL liquidity.
  - Change SDL valuation in banks’ portfolios from flat mark up of 25 basis points to differential valuation based on secondary market or auction prices (June 2018).
  - Lower margin requirements for rated SDLs by 1 percent to encourage public ratings (starting August 2018).
  - Increase transparency of state finances: publication of monthly data with a month's lag on financial accommodation and investments (starting November 2017) and market borrowings (starting June 2018).

### Conclusions on market discipline for state finances
- Market discipline can help maintain prudent state finances, particularly when complemented by strong fiscal rules and credible no-bailout commitments.
- Relatively low-hanging reforms: strengthen state data quality/timeliness and continue liberalizing financial markets.
- An explicit bailout framework (including bail-in features) that imposes costly adjustment on states and creditors could help weaken bailout expectations and strengthen market discipline.

---

### Rising FDI: trends, determinants, and policy recommendations
- Recent FDI trends:
  - FY2016/17 gross FDI flows to India: US$60billion.
  - Net FDI flows: increased from ~0.8 percent of GDP pre-GFC to 1.3 percent post-GFC.
  - Net FDI flows cover about two-thirds of the current account deficit.
  - 60 percent of FDI originates from Singapore and Mauritius.
  - Most FDI is greenfield and targets India's domestic market; IT services more export-oriented.
- Policy reforms since 2014:
  - Caps on foreign investments in many sectors largely relaxed.
  - Most FDI can enter under the automatic route.
  - Recent liberalizations: financial services, retail, civil aviation, manufacturing, holding companies in pharmaceutical, power exchange, and construction.
  - Foreign Investment Promotion Board abolished; introduction of standard operating procedures and reduction of competent authorities.
- International and tax-treaty influences:
  - India-Mauritius treaty amended May 2016; capital gains tax payable on shares acquired on or after April 1, 2017 with a two-year transition period.
  - India-Singapore treaty changes agreed December 2016.
  - Share of inflows from Mauritius surged in FY2016/17 and FY2017/18 (FY2017/18 data up to December 2017).
- Empirical cross-country panel (27 emerging markets and developing economies, 2000–2016):
  - Statistically significant correlates of FDI inflows:
    - Higher per capita income,
    - Lower inflation,
    - Better access to electricity,
    - More open capital account (Chin-Ito index),
    - Better institutional quality (government effectiveness, governance).
- Quantified potential gains for India:
  - Bringing infrastructure to the median in the sample → increase in FDI inflows of 1.1 percent of GDP.
  - Bringing capital flow liberalization to the median → increase in FDI inflows of 1.9 percent of GDP.
  - Note: benefits could be smaller given some improvements since data availability.
- Policy recommendations to sustain FDI:
  - Sustain reform momentum to facilitate investment liberalization and capital flow liberalization.
  - Improve quality of institutions and ease of doing business, including enforcement of contracts.
  - Invest in reliable quality infrastructure to reduce production and transportation costs.
  - Pursue supply-side reforms to facilitate business operations for domestic and foreign investors.

---

### Scenario analysis — labor market reforms and reallocation gains
- Focus: reallocation gains from labor reforms, especially in states with high informality.
- Calibration: shifting an Indian state to the best performer (index=1) using estimated coefficients from Equation 3 in Table 1.
- Main result: TFP gap can be significantly reduced; West Bengal and Kerala likely top gainers.
- Figure: India: Distribution of TFP Gap in States with High Informality (text figure scale: 30%, 50%, 70%, 90%, 110%, 130%).
- Table 1 (selected coefficients; dependent variables: Median TFPR, Variance TFPR, TFP gap):
  - Labor reform: -0.296*** (0.073); -0.179*** (0.059); -0.206* (0.117)
  - Credit per capita: -0.039** (0.019); 0.049*** (0.014); 0.077** (0.031)
  - PMR: -0.059** (0.026); -0.055*** (0.019); -0.039 (0.039)
  - Informality: 0.034** (0.015); -0.038*** (0.011); -0.076*** (0.023)
  - Number of firms: -0.006 (0.018); -0.006 (0.012); 0.200*** (0.027)
  - Rail density: 0.046** (0.019); -0.104*** (0.013); -0.085*** (0.031)
  - Observations: 1,154 (all columns)
  - R-squared: 0.180 (col 1), 0.534 (col 2), 0.214 (col 3)
  - Note: logs used for several variables; robust standard errors in parentheses; significance: *** p<0.01, ** p<0.05, * p<0.1.
- Table 2 (selected coefficients; dependent variable: TFP gap):
  - Labor reform: -0.037 (0.180); 0.113 (0.184); 0.123 (0.219)
  - Credit per capita: 0.069** (0.028); 0.127*** (0.033); 0.124*** (0.041)
  - Credit per capita * External dependence (Median): -0.070** (0.033)
  - Labor reform * Informality (Median): -0.550** (0.266); -0.850*** (0.291); -0.878** (0.405)
  - Informality (Median): 0.416* (0.217); 0.649*** (0.238); 0.672** (0.334)
  - Number of firms: 0.154*** (0.025); 0.193*** (0.028); 0.194*** (0.028)
  - Rail density: -0.107*** (0.037); -0.166*** (0.044); -0.166*** (0.044)
  - Installed electricity capacity: share of India's total: -1.683*** (0.530); -1.680*** (0.532)
  - Observations: 1,154 (all columns)
  - R-squared: 0.213 (col 1), 0.223 (cols 2–3)

### Labor market policy recommendations
- Modernize labor regulations to improve labor market flexibility and increase formal employment.
- Targets: reforms to the Industrial Disputes Act of 1947 and restrictive clauses under the Factories Act of 1948 to enhance flexibility and allow firms to expand and reach economies of scale.
- Streamline and reduce the number of labor laws (currently number around 250 including both center and states).
- Labor market reforms will help reap the demographic dividend and economies of scale benefits from the national GST.

*Source: GST: Considerations for a Simpler Rate (IMF background paper for the 2018 Article IV consultation with India), July 2, 2018.*

### 1. GST Incidence Under Current Structure ______________________________________________ 6

### 1. GST Incidence Under Current Structure

### A. Introduction — context and motivation
- The GST was introduced on July 1, 2017, subsuming central excises, state VATs, central service tax, countervailing and additional duties, and numerous levies, and bringing services into the state tax net.
- India’s GST has multiple non-zero rates of 5 percent, 12 percent, 18 percent, and 28 percent; special low rates of 3 percent on gems and jewelry and 0.25 percent on rough diamonds; and a GST “cess” on demerit goods.
- Among 115 countries with VATs, 49 have a single rate and 28 have two rates; India is in a small group of five countries having four or more GST rates.
- Multiple rates arose partly from fitting pre-GST tax differentials into a revenue-neutral GST.
- High compliance and administrative costs can result from:
  - Legislative complexity (exclusions, exemptions, deductions, rate differences, frequency of changes);
  - Procedural requirements (supplementary documentation);
  - Nature of clientele (dealing with non-registrants);
  - Verification costs under high informality.
- Evidence and estimates:
  - Overall tax compliance costs can range between 2–10 percent of revenue yields, and be as high as 2½ percent of GDP (Barbone et al. (2012)).
  - For large Indian firms, anecdotal evidence suggests GST-related compliance costs increased to 0.2 percent of total costs (excluding switch-over costs of about the same level).
  - Compliance costs are generally regressive.

### B. Empirical findings on incidence under the current GST
- Estimated total incidence includes direct incidence on taxed goods/services and indirect incidence from embedded input taxes on exempted goods.
- Estimated average effective GST rates by household consumption quintile under the current GST rate structure (as of January 2018):
  - Lowest quintile: 9.0 percent
  - Fourth quintile: 9.6 percent
  - Topmost quintile: 10.5 percent
- Indirect incidence due to exemptions (embedded input-tax costs) is regressive:
  - Lowest quintile faces an additional 2.5 percent effective GST rate from indirect incidence.
  - Highest quintile faces an indirect incidence of 1.7 percent.
- Conclusion: the current GST design yields a progressive direct incidence, but exemptions produce regressive indirect effects that partially erode progressivity.

### C. Simulated rate-structure scenarios and outcomes
- Single (flat) rate simulation:
  - A flat 10 percent GST rate (with current exemptions) was simulated to yield about the same aggregate GST revenue on the given consumption profile.
  - Under this flat 10 percent rate, total incidence becomes 10 percent for all quintiles (the indirect incidence from exemptions erodes direct differences).
  - The flat 10 percent simulation raises 99.4% of the revenue raised under the current GST structure.
  - Effect: effective GST rises significantly for lower quintiles and falls for the highest quintile (politically challenging).
- Dual-rate simulation:
  - A revenue-neutral combination of a 9 percent standard rate and a 25 percent high rate (applied to items currently taxed at 28 percent), retaining current exemptions, was simulated.
  - Resulting total GST incidence by quintile:
    - Lowest quintile: 9.6 percent
    - Highest quintile: 10.1 percent
  - The dual-rate simulation raises 99.6% of the revenue raised under the current GST structure.
  - Effect: modestly progressive incidence, with a lower standard rate reducing the burden on poorer households relative to a single 10 percent rate.
- Potential adjustments to improve progressivity:
  - Apply the higher rate more selectively to exclude consumption patterns of poorer households.
  - Adjust the top rate higher if needed.
  - Eliminate exemptions to remove the regressive indirect incidence from uncredited input taxes.

### D. Caveats, distributional and administrative considerations
- Data quality and under-reporting:
  - Analysis uses NSS Household Consumption Expenditure data; systematic under-reporting of high-value items would understate progressivity under the current GST.
  - Even allowing for under-reporting, a dual rate would likely remain progressive relative to the current structure.
- Impact on small businesses:
  - Concern: a uniform rate could increase effective GST payable by small firms, potentially causing exit and adverse employment/output effects.
  - Counterpoint: resources freed by exiting firms would likely be absorbed by firms able to grow and operate under a uniform tax regime.
- Treatment of firms outside the GST net and threshold rules:
  - Registration threshold: annual turnover threshold INR 2 million or US$29,400.
  - Firms with turnover between INR 2 million and INR 15 million (US$ 220,500) pay a flat 1 percent tax, cannot charge GST on sales, and cannot avail input tax credits.
  - Scale of firms (2016 Economic Census of India):
    - 58.5 million establishments in operation;
    - 45.4 million in non-agriculture (including public sector);
    - 10.4 million firms registered under GST, of which 1.3 million are under the “composition scheme”.
- Two illustrative cases for exempt firms’ input profiles and implications:
  - Case 1: Exempt firms purchase inputs and pay GST on them (cannot claim credits). Embedded tax costs add to indirect incidence; if exempt firms predominantly supply poorer households, GST is less progressive than estimated.
  - Case 2: Exempt firms have zero or minimal purchased inputs. Then current GST incidence would be lower than estimated in Section B; incidence under flat/dual rate scenarios depends on how exempt firm shares change.

### E. Key trade-offs and policy implications
- Fewer rates and fewer exemptions reduce compliance and administrative costs and opportunities for rate-shopping or lobbying.
- A move to a simpler rate structure entails equity trade-offs: a uniform rate can be less progressive unless offset by:
  - A dual-rate design with a lower standard rate plus a high rate on select items,
  - More targeted application of high rates,
  - Elimination or reduction of exemptions that generate regressive indirect incidence.
- The dual-rate option (9 percent + 25 percent top rate) can preserve modest progressivity and retain near-revenue neutrality while lowering compliance complexity relative to the existing multiple-rate system.

*Source: GST: Considerations for a Simpler Rate (IMF background paper for the 2018 Article IV consultation with India), July 2, 2018.*

### 15.      Simplifying the GST is possible without imposing a significantly higher burden on the

### 15.      Simplifying the GST is possible without imposing a significantly higher burden on the poor.

### GST simplification: findings and implications
- A dual rate structure with a low standard rate (and high rate on high-value consumption items) would still allow for progressivity.
- Rationalizing exemptions by eliminating the regressive indirect incidence from unrefunded input tax costs would preserve progressivity.
- There are likely significant benefits from lower costs of compliance and administration:
  - The literature on VAT compliance costs shows broad variation across countries; there is a consensus that compliance costs are regressive, and administrative costs increase with complexity.
  - Evidence on India is nascent; anecdotal evidence from large firms indicates sizable increases in costs, which may be even more burdensome for smaller firms.
  - Streamlined rates would weaken incentives to lobby for lower rates.
- Conclusions appear broadly robust to caveats: while data constraints preclude accurately assessing all implications, the conclusions appear to hold under plausible cases.

### Key statistics and qualitative notes (from GST analysis)
- Evidence on compliance costs: characterized as regressive; administrative costs increase with complexity.
- Indian household consumption data used: NSS 66th Round Consumption Expenditure Survey (2011–12), with more than 100,000 households covering nearly 350 goods and services.

### Methodology (Appendix I)
- Scope of GST subsumption:
  - Central taxes subsumed: central excise, central service tax, counter-vailing duty, special additional duty, and additional surcharges and cesses.
  - State taxes subsumed: state VAT, central sales tax (levied by states), luxury tax, entertainment tax, entry tax, advertisement tax, purchase tax, and lotteries and gambling taxes.
- Effective GST rate calculation:
  - Pre-tax weights for goods and services in household consumption (from NSS data, gross of pre-GST indirect taxes) are calculated.
  - Item-wise GST rates are mapped to these consumption weights to calculate the effective GST rate for each household.
  - The effective rate includes:
    - Direct incidence: weighted sum of non-exempt goods and services’ tax rates.
    - Indirect incidence: weighted sum of embedded input tax costs in exempt goods and services, which are not input-tax creditable and thus are assumed to pass on fully to consumer prices, except for electricity and water.
  - Indirect incidence estimated using input-output information, applying Leontieff-inverse coefficients to weight the share of a given input good/service in the output of a given (exempt) good/service. Goods excluded from the GST (such as fuels) are treated as an exempt good for this exercise.
- Revenue-neutral scenarios assessment:
  - Scenarios assessed on the same household consumption data by applying alternative tax (GST) rates on the goods and services, mapping as closely as possible to the items listed under the GST and the items recorded in household consumption expenditure.
- Data sources used:
  - Household consumption expenditure: NSS 66th Round Consumption Expenditure Survey (2011–12), with more than 100,000 households covering nearly 350 goods and services.
  - Rates of center and state taxes subsumed by GST, rates on GST: central and state government documents (World Bank), GST website.
  - Input structure of the Indian economy: Input-Output Tables of the Indian Economy 2007/08.
  - Concordance between rate schedules, consumption expenditure classification, and input structure classification: staff estimates.

### Policy implications from GST analysis
- Simplifying rate structure (e.g., dual rates) and rationalizing exemptions can maintain progressivity while lowering compliance and administrative burdens.
- Reducing complexity can lessen regressive compliance costs and administrative costs, and reduce lobbying pressure for lower rates.

---

### Fiscal discipline in Indian states: market-based and other options

### Recent trends and fiscal context
- States’ finances have deteriorated in recent years; states are a key determinant of general government public finances.
- Adoption of 3 percent of GDP fiscal deficit limit in early-to-mid 2000s helped improve fiscal positions: aggregate deficits of states declined from above 4 percent of GDP to 2 percent of GDP by FY2010/11.
- Since FY2010/11, deficits of states have been on a rising trajectory, though states have largely adhered to the 3 percent of GDP deficit limit.
- The states’ share of the general government deficit increased from 23 to 43 percent, as their expenditure share rose by about 10 percentage points and their revenue share by around 4 percentage points.
- General government debt hovering around the 70 percent of GDP mark and the states’ share estimated at just over 25 percent of GDP (FY2017/18 budget estimates) — consolidation remains a key fiscal policy priority.
- About 140 basis points of increase in state debt to GDP over the last 2 years is explained by broad subscription by states to the UDAY scheme (states took over the debt of state electricity distribution companies).

### Market borrowing and perceived guarantees
- States’ borrowing from the market has grown significantly: share of states’ liabilities to the market rose from less than a fifth of outstanding liabilities in 1992 to more than half in FY2016/17.
- Despite market borrowing growth, state borrowing is perceived to be backed by central guarantees:
  - Except for loans from banks/financial institutions and contingent liabilities, other instruments (market and external borrowings) are perceived as implicitly guaranteed by the center.
  - RBI acts as guarantor for creditors by imposing stop-payments on state spending and having a first claim over state revenues to ensure repayment.
  - Bunching issuance of heterogenous states contributes to less differentiation among states; some recent differentiation observed for Maharashtra, Tamil Nadu, and Telengana.

### Empirical evidence on market discipline
- Model specification: dependent variable is the weighted-average state bond (SDL) yield minus the yield on ten-year central government bonds in state i and year t.
- State fundamentals vary widely:
  - Interquartile range for state real growth varies from 3 percent to 17 percent.
  - State deficit-to-GDP ranges from 4 percent to 13 percent.
  - State debt-to-GDP ranges from 18 percent to 35 percent.
  - Range in spreads is at most 100 basis points and exhibits a tighter range for non-special category states.
- Econometric results:
  - State fiscal fundamentals are not significant and explain only 5 percent of the variation in spreads.
  - Adding liquidity conditions and global returns on bonds increases explanatory power to 70 percent of the variation in spreads, with both variables significant at the 1 percent level.
  - Robustness: results hold across various models including dummies for political alignment with the center, early adoption of fiscal rules, and higher-than-average reliance on transfers; excluding special category states does not impact baseline results.

### Comparative literature
- International evidence (mostly advanced economies) finds market discipline effects:
  - Direct effects between sub-national government (SNG) spread and fiscal fundamentals found for the United States, Canada, Germany, Australia, and Switzerland — SNGs with higher debt and deficits typically face higher spreads.
  - Interaction evidence between fiscal institutions (e.g., expenditure/debt/revenue rules) and fundamentals exists for the United States, Euro Area, and Switzerland. Examples:
    - United States: states with prudent fiscal rules face smaller increases in spreads after fiscal shocks compared to states with revenue limits.
    - Switzerland: tight fiscal rules reduce the effect of debt on spreads; credible commitment to no bailout narrowed cantons’ spreads.

### Strengthening market discipline in India: recommended conditions and reforms
- Literature identifies four enabling conditions for market discipline (Lane (1993) and Ter-Minassian (2007)):
  - Free and open financial markets:
    - Recommendation: continue to lower the statutory liquidity ratio (SLR) requirement to liberalize financial markets, improve bond market liquidity, and strengthen foundations for market discipline (as noted by the Financial Stability Assessment Program (FSAP) concluded in 2017).
  - Timely and adequate data on SNGs:
    - Recommendation: improve quality, coverage, and timeliness of state-fiscal data. Current publication lags and lack of information on the wider state public sector are shortcomings. Brazil cited as an example with quarterly SNG fiscal data disaggregated below the SNG level.
  - Flexibility to respond to market signals:
    - Note: With the adoption of the GST, states can no longer set indirect tax rates independently and can only act through consensus in the GST Council; direct taxes are solely levied by the center. This may have reduced states’ revenue autonomy relative to the pre-GST regime.
    - Evidence suggests revenue flexibility supports market discipline; a buoyant GST could relieve revenue constraints.
  - Strengthening no-bailout expectations:
    - Recommendation: constrain no-bailout expectations by adopting explicit bailout frameworks with bail-in features for creditors to make fiscal imprudence costly and give creditors incentives to discriminate across states based on fiscal health.
    - Examples:
      - Spain: ex-post bailout framework combining tough sanctions for SNGs that miss fiscal targets (including potential loss of budgetary powers), while providing financial assistance and requiring restructuring plans.
      - Korea: early warning system for local government finances using timely data to flag risks; SNGs must submit deficit management plans, face central intervention, and may have debt issuance suspended.
    - Alternative: an insolvency framework involving debt restructuring and asset sales, though likely less relevant in the Indian context.

*Source: cr18255 - 15.      Simplifying the GST is possible without imposing a significantly higher burden on the*

### 13.      Reforms could initially focus on improving data quality and further liberalizing

### 13.      Reforms could initially focus on improving data quality and further liberalizing

### Strengthening market discipline and state debt markets
- Reforms to improve data quality and further liberalize financial markets would:
  - Strengthen the ability of the market to discriminate across states.
  - Improve the market for state debt.
- Over the medium term, strengthening the no-bailout expectation could proceed with the adoption of an explicit bailout framework.
  - Even without bail-in features, such a framework would help achieve the primary objective of maintaining prudent fiscal policies at the state level.
  - Stronger fiscal rules would reinforce the primary objective and enable market discipline.
- Differentiation in borrowing costs could be introduced using differentiated risk-weights, though this would:
  - (i) require high quality state fiscal and other data — a condition that also strengthens market discipline, and
  - (ii) may be problematic politically, as the regulator would become the focal point for states’ borrowing costs.

### RBI measures to increase yield-differentiation across states
- Measures introduced by the RBI that should help increase yield-differentiation across states include:
  - Shifting to weekly from fortnightly auctions so that issuance sizes are smaller and evened out to increase SDL liquidity (October 2017);
  - Changing SDL valuation in banks’ portfolios from a flat mark up of 25 basis points over the center’s government securities’ yield to differential valuation based on secondary market or auction prices (June 2018);
  - Lowering margin requirements for rated SDLs (starting August 2018) by 1 percent compared with other SDLs to encourage states to obtain public ratings;
  - Increasing transparency of state finances, including through publication of monthly data with a month's lag on (i) financial accommodation availed by State Governments under various facilities, (ii) investments (both starting November 2017), and (iii) market borrowings (starting June 2018).

### Conclusions on market discipline for state finances
- Market discipline may be a useful channel to maintain prudent state finances; international evidence shows it can be effective, particularly when complemented by:
  - Strong fiscal rules, and
  - Commitments to no bailout.
- Relatively low-hanging reforms to boost market discipline:
  - Strengthen data quality and timely availability among states.
  - Continue to liberalize financial markets.
- The introduction of GST may have de-jure reduced revenue autonomy at the state level; however:
  - A buoyant and productive GST would prevent potential revenue constraints on state governments.
  - Indian states appear to have a relatively high degree of revenue and expenditure autonomy overall compared to other federations.
- Weakening the perception of central bailouts could credibly be achieved by adopting an explicit bailout framework (including with bail-in features) that imposes costly adjustment on states (and creditors), strengthening the foundations for prudent management of state finances.

*Italicized source attribution line.*

### RISING FDI: SOME CONSIDERATIONS

### Overview and recent trends
- FDI inflows to India have increased significantly in recent years.
  - In FY2016/17, gross FDI flows to India reached a record high of US$60billion.
  - Net FDI flows have grown from an average of about 0.8 percent of GDP before the global financial crisis (GFC) to 1.3 percent post-GFC.
  - Net FDI flows cover about two-thirds of the current account deficit.
  - Most FDI flows to India—60 percent of the total—continue to originate from Singapore and Mauritius.
- The bulk of FDI inflows is mostly for greenfield investments and likely adds to capital accumulation over time.
- Most foreign firms focus on India’s domestic market; IT services are more export-oriented.
- Cross-state FDI and exports suggest FDI may be associated with exports; formal causal analysis was not performed due to data limitations.

### FDI policy reform in India
- Since 2014, FDI policy reforms resulted in a permanent regime change to allow freer flows:
  - Caps on foreign investments in many sectors have largely been relaxed.
  - Most FDI inflows can now enter under the automatic route.
  - Recent liberalizations include FDI in financial services, retail, civil aviation, manufacturing, holding companies in pharmaceutical, power exchange, and construction.
  - The Foreign Investment Promotion Board has been abolished to streamline and expedite approvals.
  - Efforts to facilitate FDI include introduction of standard operating procedures and reduction of competent authorities.

### International and tax-treaty influences on FDI
- Country experiences suggest FDI liberalization can help attract FDI flows.
  - Countries with less restrictions on FDI inflows (OECD FDI restrictiveness index) are associated with higher FDI inflows.
  - An event analysis across 22 FDI liberalization episodes of 18 emerging economies (1997–2016) indicates median FDI inflows per capita increased by about 50 percent and average FDI inflows per capita nearly doubled in the six years after liberalization.
- Changes in international taxation could temporarily boost FDI to India:
  - The India-Mauritius tax treaty was amended in May 2016, with a capital gains tax payable on shares acquired on or after April 1, 2017 with a two-year transition period.
  - Similar changes in the India-Singapore treaty were agreed in December 2016.
  - Share of inflows from Mauritius surged during FY2016/17 and FY2017/18 compared to previous years.
  - FY2017/18 data are up to December 2017.

### Empirical analysis of FDI determinants
- An empirical cross-country panel regression (unbalanced, fixed effects) was estimated for 27 emerging markets and developing economies during 2000–2016.
- Explanatory variables include income level, trade and capital account openness, tax burden, demographics, infrastructure, and quality of institutions.
- Main statistically significant findings for FDI inflows:
  - Higher per capita income, lower inflation (proxy for a stable macroeconomic environment), and better access to electricity (proxy for infrastructure quality) are positively correlated with FDI.
  - A more open capital account (measured by the Chin-Ito index) is positively correlated with FDI.
  - Institutional quality, as indicated by government effectiveness and quality of governance, matters.

### Quantified potential gains for India
- Bringing infrastructure and capital flow liberalization to the median level in the sample would lead to an increase in FDI inflows of 1.1 and 1.9 percent of GDP, respectively.
  - Note: benefits could be smaller given some improvements in these indicators since the year of data availability.

### Policy recommendations to sustain FDI inflows
- Sustain reform momentum to:
  - Facilitate investment liberalization and liberalizing capital flows to ease operations of foreign investors.
  - Improve quality of institutions and ease doing business, including strengthening enforcement of contracts.
  - Invest in reliable quality infrastructure to reduce production and transportation costs and increase attractiveness for investment.
  - Pursue supply-side reforms to facilitate business operations of both domestic and foreign investors.

*Italicized source attribution line.*

### Box 1. Country Experiences with FDI Liberalization

### Box 1. Country Experiences with FDI Liberalization

### Overview
- Several countries have been successful in mobilizing inward FDI, which has played an important role in their economic development and export success.
- Country experiences suggest FDI liberalization is most effective when embedded in a broader reform agenda alongside economic development, an improved investment climate, and strengthened institutional capacity.
- Reform should be a gradual and continuous process to help reap the benefits of further openness while minimizing potential disruptions.

### Country experiences
- South Korea
  - FDI liberalization started in the early 1980s, with the opening of many business categories to foreign investment, significantly lowering the minimum investment level, as well as relaxing government controls on FDI.
  - In the early 1990s, further easing FDI regulations, expanding the number and range of sectors open to FDI, reducing corporate taxation for FDI firms, relaxing regulations on foreign ownership of land, simplifying approval procedures, and increasing efforts to promote inward FDI.
  - The Foreign Investment Promotion Act enacted in 1998 further eased regulations and restrictions on foreign investment and streamlined administrative procedures, while expanding the range of tax incentives.
  - InvestKorea was established in the early 2000s to facilitate FDI.

- Malaysia
  - First relaxed foreign investment restrictions in the 1980s, providing exemptions for exporters and pioneer industries from equity rules that required the Foreign Investment Committee (FIC) to screen incoming investments and from a cap of 30 percent for foreign equity.
  - In 2003, such exemptions were extended to companies located in the Multimedia Super Corridor and almost all manufacturing sectors.
  - The most important step toward FDI liberalization was the abolishment of the FIC in 2009, and thus the removal of the FIC Guidelines governing foreign equity limits.
  - At present, restrictions on foreign investment in many services are retained, but further liberalization targeting services sectors is taking place.

- Brazil
  - Change to the investment regime took place in the 1990s, as the FDI registration process and costs of entry were simplified and a system to promote investments and the transfer of technology was set up.
  - In 2002, Investe Brasil was established to promote investments particularly in infrastructure, tourism, and agribusiness, as well as to provide information on investment regulations and incentives.
  - A privatization program and regulatory reforms to foster competition also played a role.

- China
  - China has taken a gradual approach to FDI liberalization, where liberalizing FDI has continued to be part of five-year plans for economic and social development since the Open Door Policy.
  - In the 1980s and 1990s, China experimented with opening foreign investment in selected coastal cities and in special economic zones and industrial parks with a focus on attracting export-oriented manufacturing FDI.
  - In the 2000s, China made a radical commitment to services liberalization in its accession to the WTO.
  - China is now quite open to FDI in almost all manufacturing and most service industries, except for finance and telecommunications.

- Indonesia
  - Liberalized its investment regime through many rounds of reforms beginning in the mid-1980s.
  - The Asian financial crisis led to substantial liberalization, particularly in the banking sector and for acquisitions of local firms.
  - Indonesia has no general approval process for investment that might discriminate against foreign investors; however, foreign equity restrictions in many sectors, particularly in services, remain.
  - Political and economic reforms as well as institutional building have complemented the FDI liberalization process, providing macroeconomic stability, policy certainty, and an improved investment climate.

*Source: OECD’s Investment Policy Reviews for countries listed above.*

### 8.  Scenario analysis suggests labor

### 8. Scenario analysis suggests labor market reforms would help reduce productivity losses

### Scenario analysis: reallocation gains from labor reforms
- Focus: potential gains from reallocation resulting from labor reforms, particularly in states with high informality.
- Calibration: impact of shifting an Indian state to the same level of the best performer (index=1) using estimated coefficients from Equation 3 in Table 1.
- Main result: The TFP gap can be significantly reduced, with West Bengal and Kerala likely being the top gainers (Text Figure).
- Policy implication: Removing structural rigidities in labor would reduce distortions and contribute to productivity gains and higher long-term growth.

### Key statistics and graphical finding
- Text Figure (India: Distribution of TFP Gap in States with High Informality) reports Average TFP gap and TFP gap if labor reform=1 across states (visual scale showing 30%, 50%, 70%, 90%, 110%, 130% with West Bengal and Kerala among top gainers).
- States listed in figure: WEST BENGAL, MAHARASHTRA, KERALA, TAMIL NADU, RAJASTHAN, HARYANA, PUNJAB, GUJARAT.
- Label in figure: "States with less progress on labor market reforms" and "States with more progress on labor market reforms".
- Figure source: IMF Staff Estimates.

### Table 1: India: Misallocation and Labor Market Reforms — selected coefficients (Dependent Variables: Median TFPR, Variance TFPR, TFP gap)
- Labor reform: -0.296*** (column 1), -0.179*** (column 2), -0.206* (column 3)
  - Standard errors: (0.073), (0.059), (0.117)
- Credit per capita: -0.039** (0.019), 0.049*** (0.014), 0.077** (0.031)
- PMR: -0.059** (0.026), -0.055*** (0.019), -0.039 (0.039)
- Informality: 0.034** (0.015), -0.038*** (0.011), -0.076*** (0.023)
- Number of firms: -0.006 (0.018), -0.006 (0.012), 0.200*** (0.027)
- Rail density: 0.046** (0.019), -0.104*** (0.013), -0.085*** (0.031)
- Observations: 1,154 (all columns)
- R-squared: 0.180 (col 1), 0.534 (col 2), 0.214 (col 3)
- Note: Credit per capita, the number of firms, rail density, and unregistered net state domestic product as a proxy for informality are in logs. Dependent variables: median of log TFPR (col 1), variance of log TFPR (col 2), TFP gap (col 3). All columns include industry and year fixed effects. Robust standard errors in parentheses. Significance: *** p<0.01, ** p<0.05, * p<0.1.

### Table 2: India: TFP Gap, Labor Market Reforms, and Informality — selected coefficients (Dependent variable: TFP gap)
- Labor reform: -0.037 (0.180) (col 1), 0.113 (0.184) (col 2), 0.123 (0.219) (col 3)
- Credit per capita: 0.069** (0.028), 0.127*** (0.033), 0.124*** (0.041)
- Credit per capita * External dependence (Median): -0.070** (0.033) (cols 1–3)
- Labor reform * Informality (Median): -0.550** (0.266) (col 1), -0.850*** (0.291) (col 2), -0.878** (0.405) (col 3)
- Informality (Median): 0.416* (0.217), 0.649*** (0.238), 0.672** (0.334)
- Number of firms: 0.154*** (0.025), 0.193*** (0.028), 0.194*** (0.028)
- Rail density: -0.107*** (0.037), -0.166*** (0.044), -0.166*** (0.044)
- Installed electricity capacity: share of India's total: -1.683*** (0.530), -1.680*** (0.532) (cols shown)
- Observations: 1,154 (all columns)
- R-squared: 0.213 (col 1), 0.223 (cols 2–3)
- Note: Credit per capita, the number of firms, rail density, and unregistered net state domestic product as a proxy for informality are in logs. All columns include industry and year fixed effects. Robust standard errors in parentheses. Significance: *** p<0.01, ** p<0.05, * p<0.1.

### Policy recommendations (labor market focus)
- Modernize labor regulations to improve labor market flexibility and increase formal employment.
- Key targets: reforms to the Industrial Disputes Act of 1947 and restrictive clauses under the Factories Act of 1948 to enhance labor market flexibility and allow firms to expand and reach economies of scale.
- Streamline and reduce the number of labor laws (currently number around 250 including both the center and states).
- Labor market reforms will help reap the full benefits of the demographic dividend and economies of scale from the new national goods and services tax.

*Source: IMF Staff Estimates; content derived from the IMF Country Report text and tables.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18255.pdf_