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The Nutgraf : The Fence Test

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The Nutgraf

Today marks two months since I’ve been in isolation, all by
myself in my apartment in Bengaluru, India.  

There’s a lot of literature about the perils of extended confinement with no human interaction. Fortunately, for the most part, I have been okay. If you are with your loved ones at home, getting on each other’s nerves—you are the lucky ones. And both of us are far, far more fortunate than those in the heartbreaking photos and videos we’ve seen walking across the country to get back home to their loved ones. 

Keep faith. This too shall pass. If you are also in solitary isolation, write a weekly newsletter. It really helps. 

Let’s dive in. 

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India doesn’t understand Chesterton’s Fence Test

Last week, the Prime Minister of India, Narendra Modi, announced a giant fiscal stimulus package of Rs 20 lakh crore (~$300 billion) for the country. This accounts for nearly 10% of India’s GDP, and by this metric, it is one of the largest stimulus bills by any country. 

Unsurprisingly, most of the media went nuts. 

Look, stimulus packages are all about the details. The topline number is usually showmanship, often calculated using several arbitrary assumptions. Despite this, India’s Prime Minister took it one step further: he announced the 20 lakh crore number exactly at 20:20 hours, in the year 2020—a narrative flourish which wasn’t lost on his critics.

Anyway, the details of the stimulus slowly started trickling in over the week from the Finance Minister, Nirmala Sitharaman. In a series of announcements, she unveiled them across multiple areas. In Micro, Small & Medium Enterprises (MSMEs). In tax structures, particularly in TDS (Tax Deductible at Source), and in agriculture, one of India’s key areas. 

I’ll skip the part where the monetary value of the stimulus appears meaningless, because enough has been written about it already. 

Instead, I called a friend—a subscriber, who also owns a small business in Nagpur, Pune. 

I asked him what he thought of the reforms. 

“Have you heard of Chesterton’s Fence?” he asked.

I confessed I hadn’t. 

So he explained it to me. 

GK Chesterton is a famous writer. In 1929, he published a book called ‘The Thing’. In it, he describes a heuristic. This is the relevant quote

There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”

In other words, what GK Chesterton is saying is: 

Do not remove a fence until you know why it was put up in the first place.

Chesterton’s Fence is a way of thinking about the world. It’s a rule that’s used by Wikipedia for edits. Don’t change something until you know why it was there in the first place. It’s also a way to look at reforms, and to understand the second order effects of an action. 

India’s stimulus package, though likely well-intentioned, ignores this. While a 20 lakh crore number looks and sounds impressive, and while some of its measures are good, it ignores why things are the way they are today. Sure, several of them aren’t great and need to be changed, but it’s important to understand them before hacking away at them. 

India is tearing down fences without understanding why they are there in the first place.  

Part of what we do every week is explain how things that look simple on the surface are quite complex underneath. In this section, thanks to my conversation, I’ll illustrate this using three examples—all in the context of the stimulus package and reforms. 

1. MSMEs hate to be defined

In the first tranche, the finance minister announced a series of reforms to help MSMEs. The assistance was in the form of credit. Over 45 lakh MSME units across the country would be able to avail collateral-free loans worth Rs 3 lakh crore, with fairly generous repayment periods. MSMEs have been hit the worst thanks to the lockdown, so this measure, broadly, is quite welcome. Give help to the ones who have been hit the hardest. 

However, in the announcement, there was a change. 

The government Wednesday broadened the definition of Micro, Small and Medium Enterprises (MSMEs) by revising the limit of investment in machinery or equipment and introducing a “turnover” criteria — a reform measure that seeks to reverse the traditional policy bias in favour of units staying small in order to qualify for benefits.

“The definition being changed is done in the favour of MSMEs. There has always been this fear, among successful MSMEs also, that if they outgrow the size of what has been defined as an MSME, they will lose their entitled benefits. This is why MSMEs like to remain within the definition rather than grow. With the revised definitions of MSMEs, they will not have to worry about growing their size and can still avail benefits,” Finance Minister Nirmala Sitharaman said.

On the face of it, this isn’t a bad idea. Why should investment amount be a criteria for defining whether a company should receive benefits? Turnover seems a lot more sensible. 

Except…this Indian Government tried this definition in the past and ran into considerable opposition. 

…the revision of the definition of MSMEs in the country has been long and multiple governments have tried it for a number of years. In fact the Narendra Modi government had moved ahead to amend the definition in its very first term in power, but had to scale down due to opposition from the RSS affiliates.

The existing definition was linked to investment in plant and machinery, but the government was pushing for turnover-based classification. However, powerful lobby groups such as Swadeshi Jagran Manch and Laghu Udyog Bharti, have always argued that any change in definition to only a turnover-based would mean traders and assemblers who import from China and put together a product, could benefit at the cost of local manufacturers.

So what did the government do? It went down the middle and defined MSMEs by both criteria – by investment and by turnover. 

Which has now totally thrown this sector into confusion. Some believe that the turnover limit is too low. Others believe that now books will have to be tweaked to adjust the turnover numbers so that they don’t lose benefits. 

And for several others, something that was flawed but simple, is now flawed…and complex. 

2. Who owns Agriculture exactly?

Another initiative which was rolled out by the Centre was sweeping agricultural reforms. There were welcome changes to the Essential Commodities Act, and a bunch of other actions. 

All very good, but with one problem.

Agriculture is a state subject, not a central one. 

And the main thing that holds agriculture back is this thing called the Agricultural Produce Marketing Committee (APMC) Act. This binds farmers to sell their produce only to the APMC, and ensures that no private player can enter in. Some states are attempting to change this, but there’s some way to go. 

However, trade is a central subject. And that’s what this Government is doing. It’s introducing mechanisms to let farmers trade across states, which sort of undermines the state laws.

But is it enough?

PM Kisan scheme is the right way to go, give farmers income support, end subsidies on inputs, invest in physical infrastructure such as irrigation and command area development, storage silos, cold chains. Give farmers marketing freedom. That does not simply mean removing the Agricultural Produce Marketing Committee (APMC) Act restrictions that bind farmers to sell their produce only to the APMC. It means letting their produce move across state borders, and be exported. The Centre clamps down on exports at the first sign of food price inflation, denying farmers of extra income and killing the incentive to produce more. This must change, too.

So long as these changes are not attempted, merely throwing yet more money into rural areas will not drastically change farming. But it would be good news for Hero, Bajaj and other two-wheeler makers.

The general consensus is that you can announce what you want in agriculture, but to little consequence, not unless you figure out a way to make it work with the states themselves. 

3. TDS has two purposes

The other big announcement was a 25% reduction in the tax rate deducted at source (TDS) and tax collected at source (TCS) for non-salaried payments. 

When asked why this wasn’t done for salaried employees, Finance Secretary Ajay Bhushan Pandey offered some…interesting reasoning. 

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“If we reduced the TDS rate for salaried class then their compliance burden would have increased because they would be required to pay higher taxes at the year end along with interest. Hence TDS rate has not been cut for salaried class,” 

The point of reducing the TDS was to give short-term liquidity, which the government estimated was around Rs 50,000 crore. 

Except… 

TDS is not one but two things. It’s a tax deducted at source, but it’s also an advance tax paid by companies to the government. Only one side of the equation was relaxed. Which effectively, makes little difference. 

However, experts pointed out the move will only help taxpayers temporarily, as the tax liability remained the same and the date for advance tax has not been extended. Besides, taxpayers will need to re-work their advance tax liability to be deposited on June 15 — the first instalment. 

Naveen Wadhwa, DGM, Taxmann, said the reduction in the rate of TDS/TCS will help self-employed, professionals, and senior citizens earning interest income or rental income. “ However, it should be noted that the relaxation in the rate of TDS/TCS will not have any impact on the ultimate tax liability of a taxpayer.

Thus, any deficit in tax liability, due to the reduced rate of TDS/TCS, should be payable through advance-tax instalments. Any short-fall in the deposit of advance-tax will attract interest under Section 234B and 234C,” he said.

Fences. 

Now over to Rohin, for the India vs China perspective. 

Do as India says, not as India does

The last week has seen India aggressively walk down two paths. The first of those is for foreign countries and companies that are wary of being over reliant on China. “Make in India,” it is trumpeting at the top of its voice. We have land, labour, democracy, rule of law, and a massive domestic market.

A good summary of it was provided by two partners at consulting firm Kearney, writing in the Times of India.

The US-China trade wars and the ongoing Covid-19 crisis are accelerating a shift in global manufacturing out of China. Given this shift, India now has a never-before window of opportunity to emerge as a global manufacturing hub. With the world’s youngest workforce and a sizeable domestic market, India is demographically well positioned. A clear strategy for specific sectors/corridors, focused investments in competitiveness enablers, smart market promotion, and disciplined execution are now needed to fully capitalize on this opportunity.

The US-China trade wars have led to a decline in China’s manufacturing exports to the US. In 2018, China held a 65 percent share of US imports from Asian LCCs. By Q4 2019, China’s share had dropped to 56 percent – a significant drop within the course of a year. Of the $31 Billion that shifted from China to other Asian LCCs in 2019, almost half (46%) was absorbed by Vietnam, a fourth (27%) by Malaysia, and only 10% moved to India.

The Covid-19 crisis could further accelerate manufacturing’s shift from China. A potential crisis outcome could be an accelerated rebalancing of supply chains, with organizations looking to build a resilient and diversified manufacturing footprint. Japan has already earmarked $2.2 billion to help its manufacturers shift production out of China. Companies across US, Europe, and South Korea are looking to diversify their footprint as well.

India has a unique opportunity to win this new wave of global rebalancing.

India’s objective seems to be to become the dominant “+1” in a “China+1” strategy.

For some companies, this is not a straightforward retrenchment, but an embrace of what is known as “China+1”. The strategy is still to use Chinese suppliers, not least so as to go on serving the very attractive Chinese market, but also to encourage suppliers elsewhere in case something goes wrong. Witness Google’s reported investment in Vietnam to produce its Pixel smartphone or Microsoft’s to produce its Surface tablet. The strategy’s purported benefits, though, are not bought cheaply, argues Jake Parker of the US-China Business Council, a lobby group. It will take five years for any such reconfigured supply chain to achieve costs as low as what they would have been if based in China. In the meantime prices will have to rise.

Easier said than done, said Debashis Basu, the outspoken founder of the investigative personal finance publication, Moneylife.

Well, all this discussion about FDI is a joke because it is well known that even Indian businessmen who have a choice don’t want to invest much in India. Domestic investment has been sluggish for the past six years, as reflected in the capital goods sector. This is because domestic demand has been weak, there is overcapacity, and public investment is low. Hence, there is no incentive for domestic businesses to invest more. India is, in any case, suffering from drought in private investment.

Then there is the other path, for domestic companies and consumers. It’s called “Self-Reliant India.” As part of his address to the nation on 12 May, Prime Minister Narendra Modi talked about his vision to promote local businesses and brands. “From today, every Indian has to become vocal for their local, not only to buy local products, but also to promote them proudly,” he said.

Unfortunately, these two roads don’t really converge anywhere. If anything, they diverge.This was crystal clear to anyone whose job didn’t depend on them not understanding it, as announcements started pouring in within hours of the PM’s address.

While most newspapers, journalists, business leaders and experts chose to ignore the dichotomy of India simultaneously promoting global trade and local protectionism, respected economist and columnist Swaminathan Aiyar did not.

Global prosperity in the last century was created by a huge expansion of global trade and investment. Economist Paul Krugman, in The Age of Diminished Expectations, wrote, ‘Productivity isn’t everything, but, in the long run, it is almost everything.’ Competitive markets create a relentless search for improved productivity that spurs economic growth and prosperity. It means specialising in, and exporting, what you can do best, while importing the rest.

If, instead, you aim for self-sufficiency regardless of competitiveness, your productivity will fall behind others who globalise — the story of Jawaharlal Nehru vs Lee Kuan Yew. The Swadeshi Jagran Manch (SJM) may not understand this, but Modi must. 

Opening up does not mean de-industrialisation, as critics feared when India opened up in 1991. Modi boasts that India is helping the whole world with supplies of medicines. But, remember, when Nehru created the public sector Indian Drugs and Pharmaceuticals Ltd (IDPL) to make India self-sufficient in pharma, he failed miserably. By contrast, today’s booming pharma industry is solidly embedded in global chains, importing 70% of its ingredients from China and exporting half its output. 

It’s hard to reconcile an India that has been progressively cutting itself off from global trade (see: “The RCEP Backflip”) and promoting only locally made products, also being the country that exhorts other countries to avoid doing the same and instead outsource to it. 

That’s not how global trade works. Unfortunately, it may be too late to save it.

Don’t be fooled that a trading system with an unstable web of national controls will be more humane or safer. Poorer countries will find it harder to catch up and, in the rich world, life will be more expensive and less free. The way to make supply chains more resilient is not to domesticate them, which concentrates risk and forfeits economies of scale, but to diversify them. Moreover, a fractured world will make solving global problems harder, including finding a vaccine and securing an economic recovery. 

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That’s about it from me. 

Take care. 

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