India is ready for change

Dated 2nd October, 2014

One of India’s biggest plus points at the moment is that Modi has the backing of a firm majority of voters to push through changes.

He won May’s election by a convincing margin, and he ran as a firm pro-business candidate. (He already had a pro-business reputation thanks to a successful spell as chief minister in Gujarat.)

Since his victory, Modi has made some tentative reforms. For example, the requirement that all boilers in the country must be inspected annually by a government inspector has been relaxed.

Perhaps most importantly, finance minister Arun Jaitley plans to introduce a ‘goods and services tax’ (GST), similar to our VAT. Now, you might think that a VAT-style tax is hardly a pro-markets reform. But I’d riposte by pointing out that the Thatcher government almost doubled VAT in 1979, shortly after taking power for the first time.

You see, economists like VAT/GST because it’s a tax on consumption rather than income or profits. If you tax consumption, that should boost savings. And if you use the extra tax revenue from GST to cut income taxes, you’ll give people a bigger incentive to work hard.

That said, I doubt the new consumption tax will be wholly offset by a cut in income tax – simply because the Indian government has a large fiscal deficit. But if you’re going to reduce a deficit by raising taxes, a consumption tax is one of the best taxes to go for.

Modi’s government is also relaxing some restrictions on foreign investment. So overseas companies will now be able to own 49% of defence and insurance businesses, up from the previous 25% limit. Modi is also trying to change the culture of the public sector. He’s pushing ministers and bureaucrats to, at the very least, work a full business day.

Even better, these reforms are being introduced just as growth is picking up. GDP growth rose in the second quarter of this year to 5.7% a year, up from 4.7% in the previous quarter.