July 2007
Economy & Policy

By Madhukar SJB Rana

One feels sorry for the plight of the current Finance Minister who is left high and dry without the elusive ‘peace dividend’ as the economy languishes further into stagflation. That could enter a whirlpool of financial, then fiscal and, finally, economic crisis to dash any immediate hope for a better Nepal. Never mind a Nepal that is peaceful, prosperous and democratic.

The interim government and the interim parliament should take heed of the wisdom of Aneurin Bevan, British socialist and an architect of its modern welfare state, that “freedom is a by-product of economic surplus”. There can be no freedom without profit. Such a surplus may be forthcoming for Nepali citizens–and for Nepal that is now virtually an ‘aid colony’—should the Finance Minister ponder over the suggested agenda for fiscal reforms.

Theoretical Framework for Reforms and Innovations

It is generally agreed that the objectives of fiscal policy are—or should be–(a) efficiency (i.e. how much does it cost to raise 1 Rs in tax? Does the tax have positive short-term revenue impact but with a negative long-run revenue outcome?), (b) predictability (i.e. how certain the expected revenue is?), (c) equity (i.e. are equals treated equally and un-equals unequally?), (d) neutrality (i.e. are taxes propping up investment, consumption and savings decisions by households and businesses in contravention to the market forces of supply and demand?), (e) inter-temporal impact (i.e. tax’s effect on economic growth, employment, savings, investment, capital formation, technology change, productivity, interest rate, inflation rate, foreign exchange rate, public debt etc.).

There are no studies being done in Nepal and done continuously by highly qualified public finance experts in ministries and universities as to what objectives Nepal’s fiscal policy instruments achieve or do not achieve; how are they being traded off; to what extent are monetary policies of the Nepal Rastra Bank complementing fiscal policy and so on.

Thus an innovation sorely needed is to set up a Revenue Board that functions in the manner of a revenue think tank to guide decision-makers with sound facts, figures, scenario analysis, projections and forecasts.

The exiting Revenue Review Committee could be transformed to play this role with an appropriate status, authority and with its own budget for research and analysis, statistics and surveys, documentation and publication, administration, consultation and dialogue, etc. Reviews could be just as easily be done by a Revenue Review Committee whose Secretariat should be the Ministry’s Revenue Division.

Improve Inter-Ministerial Coordination

Innovations are sorely desired beginning with the functioning of the Economic Committee of the Cabinet to oversee economic affairs much more dynamically. This Cabinet Committee should be headed by the DPM/FM and supported by a Joint Standing Committee led by the Secretary concerned for periods of six months on a rotational basis to involve Finance, Commerce & Industry, Agriculture, Tourism, Water Resources and Labour for: (a) Agro-Export Promotion and Facilitation, (b) Employment Promotion and Productivity Enhancement, (c) Cottage and Small Industries Promotion and Protection and FDI mobilization to jointly grapple with the severe constrains that they face from external competition where they lack a level-playing field; suffer severely from bureaucratic neglect and lack of harmonization of acts, policies, strategies, regulations and decisions supported by focused, data-based research and analysis (which could be contracted out to national consultants to provide).

As an example, the chronic, difficulties being faced by the incense sticks (dhoop) making industry is a classic case crying out for concerted attention to fill the void in Nepal’s development administration. Repeatedly, recommendations of the ministry concerned, association of small industries, FNCCI, labour unions etc have been totally ignored by the Ministry of Finance with the entrepreneurs running from pillar-to-post for a solution of their problems.

It is needed to underscore that this industry is 90% indigenous and should be a prime candidate for export promotion with such a high value added component. Alas, they are fighting for national survival owing to bureaucratic negligence and a pathological pre-occupation with foreign aid disbursement, which is getting worse, and is of no immediate benefit to improving Nepal’s short-run growth, employment, productivity, inflation or balance of trade indicators.

They are facing problems with a lack of a level-playing field for their products as they have to compete, in a porous border context, with dhoop-making small industries in India, which are free from all taxes. Then there is the problem that they have to pay VAT and abide by the restrictive labour laws of the land. Not to mention the lack of expert technical support whatsoever being tendered by the concerned department, which lacking the requisite technical competence on marketing and technology trends, therefore, to simply recommend tax exemptions as a panacea for industrialization, export promotion and employment-creation in Nepal.

In the current post-conflict scenario, it is now high time that the government and bureaucracy be fully focused through effective inter-ministerial coordination—on partnership with FNCCI, CNI, Nepal Chamber of Commerce and the national associations that include the small and medium entrepreneurs in urban areas. There can be no ‘liberalization’ without the active participation of the small, medium and micro-entrepreneurs in the national economy.

Improve Tax Administration

We can start by honouring all tax payers with greater privileges. Thus the government should give due recognition to PAN card holders by treating PAN cards on par with citizenship certificates for all legal, business and travel purposes.

As refunds are chronic, contentious problems in current tax administration, the Ministry of Finance should closely and regularly monitor and evaluate repayment performance, especially to the export houses. Penalties must be levied on poor performance by deducting group and individual performance points for delays in making refunds by the bureaucracy. A computerized MIS system should be established in the Office of DG to solve this chronic malaise.

Strengthen the Revenue Consultation Committee as a permanent agency to be engaged continuously in research and analysis with highly qualified professionals hired on a need basis for their expertise.

A Sub-Committee should be set up on Tax Simplification and Harmonization to (a) review all laws, rules and regulations for their legal and procedural complexities to cut down on appeals, disputes and transactions costs, (b) make public decisions by this sub-committee and the specific cases that have been decided by the Appeals Board so as to set precedents transparently based on case law for the benefit of all, and (c) recommend removal of all exemptions and specific taxes in favour of generalized across-the-board taxes and exemptions. It may be that around Rs 15-20 billion worth of imports do not pay customs duties. Once customs duties are brought down, exemptions will be unnecessary and customs fraud, evasion and the corruption will fall dramatically.

Improve enforcement all round through reorganization, re-engineering and motivating revenue administrators—customs, internal revenue, intelligence, revenue analysis and research. The government must give due priority to implementing the Task Force’s Report on Customs Administration submitted to the Minister in 2006. If implemented, this Report will change the face and style as well as the level of expertise in the Nepali central bureaucracy once and for all.

Improve Upon VAT

The introduction of VAT was compromised initially for political acceptability. This has created many anomalies as those in the PAN net have to compete with those outside with exemptions. Thus the more dynamic businesses suffer and so does employment and economic growth.

It may be the time to consider if it is not advisable to improve upon VAT by removing the exemption while simultaneously reducing the personal income tax rate and personal income tax exemptions.

Of course, a strategic decision must be made as to whether Nepal would like to opt for a full VAT or expenditure tax system or combine it with a zero income tax system or one with very low rates on the personal income of the wealthy few. If we are serious about offshore banking, attracting FDI and serving as an entrepot-transit-economy within the subcontinent and beyond into Tibet, this may be the right time to ponder the options.

Formulate a Short-Term Taxation Strategy for 2007-09

For this revisit the High-Level Committee on Fiscal Reform’s Recommendations together with those made by the International Monetary Fund to the government in the recent past while duly keeping in mind the following broad guidelines as priority considerations, for the short-run, to improve the climate for savings and investment in Nepal.

Reduce Income Taxes on Personal Income and Corporates firstly as a matter of priority: this will have a salutary real and psychological effect on business climate, enforcement of tax laws on evaders, compensating for revenue loss through expanding the scope of VAT and demonstrate political commitment to the taxation strategy to make the economy internationally competitive.

Levy a carbon emission tax on vehicles that are polluting the environment. Earmark this revenue for the health sector to fund lung diseases. Similarly, reduce significantly the customs and excise duties on electrical vehicles.

Do not tax capital gains. There is no clear research evidence that it helps secure tax objectives—growth, equity, capital formation etc.

To simplify tax administration, remove gradually to a targeted minimum sector-specific or product-specific taxes in favour of general taxes valid for all businesses equally.

Liberalization does not mean “move from ‘license-raj’ to ‘exemption-raj’. Hence gradually abolish all exemptions.

To enforce rampant tax avoidance, there should be a target to raise taxes to 17% of GDP by 2009 through better enforcement of existing laws with the lowest tax regime in all of South Asia. One may consider the feasibility of various new options to bring more into the tax base by levying a Minimum Local Development Tax on: (a) Assets (say 0.5% of preferably gross business assets or, as second choice, fixed assets); those already in the tax net may be allowed appropriate exemptions; (b) Income (say at 7% of presumed income for non-PAN card-holding informal local businesses or say 1% of gross turnover which ever is lower) and (c) introduce an agricultural income tax for holding above a certain size of land.

Finally, revise downwards the book value of all aided projects’ assets to conform to the real international competitive value of the investments by writing off the “padded costs” and costs incurred from over investments. Particularly, correct the pricing mechanism for hydro-energy to reflect the long-run marginal cost of production. Renegotiate with donors to write off Nepal’s debt servicing obligations to the full extent of such a fiscal burden.

Conclusion

The Finance Minister has much experience in budget-making. The next one will be his fourth, which is a veritable record. Hopefully, while seeking to make budgetary provisions for the 3 year interim national plan for reconstruction, rehabilitation and rural recovery he should revisit impartially the vision for Nepal as a land-bridge economy between China and India that is also the offshore international financial centre of south Asia. This vision is grounded on sound geo-politics, geo-economics and geo-psychology.

(Rana is a former Minister of Finance)

- By Chandan Sapkota

Despite new changes in the social, economic and political fronts in recent years, one issue has remained as intractable as ever. The issue related to willful defaulters and non performing loans (NPL) stockpiling in banks is one of the most persistent, stubborn, and sticky issues in the economy. This might be because of its unique nature, which has undergone transformations along with the evolving institutions and socio-political situation.

This has been one of the most debated issues in the past and still continues to be one of the thorniest issues plaguing our financial system. It has not only worsened the financial health of the two largest public banks but also put the whole economy at stake and heaped additional burden on the public. Why is this issue so persistent and adaptive to changed circumstances? Perhaps, this is more of an institutional problem now and unless the institutions dealing with it are reformed and strengthened first, it might remain persistent and adamant in the coming years as well. It also puts a question mark on the efficacy of our institutional setting and begs an answer to whether they are really capable of withstanding the aftershocks of a drastic action against willful defaulters.

First let’s keep the facts straight. NPA accounts for over 20% of the GDP. Two public banks, Nepal Bank Limited and Rastriya Banijya Bank, now under foreign management, account for most of the NPLs in the country. The impact of loan defaults in commercial banks is not that alarming, though the numbers are pretty worrisome. To maintain sound financial health of the two public banks and to repair the damage done by willful defaulters, the central bank has already spent more than five billion rupees, extracted directly from taxes. This has added per capita additional debt burden of $2.8 ($1.8 more than the poverty line) on the public. This means that the public are bearing a high cost of negligence and deliberate, unethical actions of the willful defaulters. There are around 80 big willful defaulters associated with 27 leading business houses. The number of blacklisted loans is around 2909, which amounts to almost Rs 40 billion. The defaulted loans and the amount needed to repair damage emanating from these bad loans have a very high opportunity cost because it could be used in progressive, high yielding development activities like health and education.

The present government seems to have taken this matter pretty seriously. It has initiated the process of putting constraints on willful defaulters’ activities, primarily to pressure them to repay defaulted loans. This recent action is a result of increased pressure from large and influential donors like the World Bank, IMF, and ADB, among others. It is open to debate whether the actions taken and to-be-taken against willful defaulters are relevant and appropriate at this point of time. But, given the poor institutional arrangement in the economy, we need to consider the efficacy of these reforms and contemplate whether the present institutional set up would withstand the repercussion emanating from the intended action against willful defaulters.

If we look at the list of defaulters and people responsible for massive NPLs, it would not be difficult to notice that most of them are major players in the industrial sector at present. The willful defaulters in the list own major factories and companies that are considered to be the backbone of our economy. Several export-oriented companies are owned by the defaulters. Given this condition we need to consider consequences of the action the government is trying to take lately. Reports state that the government is confiscating passports of willful defaulters and is putting restrictions on property rights and financial transactions, among others. Seizing passports would definitely limit mobility of defaulters and they might experience tremendous pressure to keep up with their business dealings. This might force them to pay long overdue loans. However, it has its flipside as well. It might demoralize current defaulters, whose firms still contribute to the industrial sector output. Moreover, restrictions on travel and seizure of passports limit their ability to expand their demand and supply chains overseas. This might hit a blow to the already deteriorating balance of trade. This is one aspect the government needs to be cautious before taking the much needed actions against the defaulters.

Moreover, intense pressure to limit financial and physical mobility of the defaulters might force them to close operations. This is a likely case because some of the defaulters would be able to repay loans only by selling their entire property and assets, meaning that they themselves would have to go bankrupt to repay loans. This might seem fair if we take into account how these defaulters ruthlessly and advertently hijacked public’s money and used it to further their needs. However, this also has its drawbacks. If the defaulters are forced to sell off their entire property to repay loans, then unpleasant conditions like factory closure and layoffs would surely emerge. There is no reason that under this pretext the government should suspend actions against the defaulters. It would be prudent and pragmatic if the government takes note of these possibilities and prepares for any consequence that might have a negative impact on the fragile economy. Planning ahead on social safety nets and insurance mechanisms to deal with these possibilities is vital to ensure that the actions against defaulters goes as planned without any destabilizing effect on the industrial base of the economy.

We also need to take into account the institutional setting in the economy. The institutions that drive the economy are still immature, not because they were established of late but because they were, and are, plagued with inefficiency, rent-seeking activities, and political maneuvering. Without setting these things right, current initiations taken by the government might turn futile. The two public banks, which bear the highest NPAs, are not in this critical condition just because defaulters did not pay loans on time. Defaulters were loaned out money without properly accessing their liabilities and credibility. This is a proof of widespread rent-seeking activity in our institutions. The officers who loaned out money to these defaulters without fulfilling all the requirements are equally guilty. Unless, these guys are brought to book, the system will remain intact and the problem would not get any better in the days ahead because the same practices would give birth to new defaulters and encourage would-be defaulters.

Additionally, we also need to look at the quality of the action the government is trying to undertake. It appears that the action is quite cumbersome and full of loopholes, which the defaulters might take advantage of to eschew negative impact in their business. For instance, in order to take action against the defaulters individual banks need to refer names and actions to the central bank, which then recommends the government to take appropriate action. The defaulters - who are still powerful thanks to their power nexus with politicians and other bureaucrats in the current institutional setting - might attempt to pressure individual banks from referring names and relevant actions to the central bank. No one can ignore the possibility of tacit agreements between defaulters and individual banks. Additionally, even if the individual banks refer names to the central bank, the defaulters might try to nip the whole process by influencing the central bank bureaucracy, which is marred by inefficiency and opaque administration. The defaulters might also try to influence the government from acting against them by engaging it in rent-seeking activities. It is not a remote possibility because our government and bureaucracy are highly susceptible to rent-seeking behavior and past experiences on governance has shown that bureaucrats tacitly act in pursuit of vested interests. Moreover, the defaulters might also go to court challenging decisions against them. This might unnecessarily lengthen the loan recovery process because it takes months to reach a verdict in our inefficient and snail-paced court proceedings. If we can clearly identify who the defaulters are, then why wait for referrals and recommendations from banks? Taking action swiftly and directly against the already known defaulters is more optimal, efficient, economic, and less cumbersome.

The points discussed above give an inkling of whether our institutional setting is able to withstand action against defaulters. Simply initiating action against defaulters is not going to yield intended results. If lucky, these steps might resolve those issues and banks might get their loans back. However, what these steps would not do is to stop the same activities from happening in the coming days, i.e. it would not discourage would-be defaulters. The only way we can restrain and discourage these kinds of activities in the future is to solidify our institutions so that they can socially, economically, politically, and morally withstand fraudulent behavior from certain section of the business community. This means that our institutions, both private and public, should not allow people with vested interests to impregnate the bureaucracy. This calls in greater action for good governance, which is not an outcome of a one shot reform. Good governance can be attained gradually by correcting inconsistencies in the economic policies. This can be attained by proper institutional reforms and set ups. Moreover, the pacing and sequencing of government-imposed reforms should aid creation of the appropriate institutional setting that can not only withstand negative consequences of NPAs and defaulters’ machinations, but it should fend off any such activities from emerging in the future. Gradual corrective policies to fine tune evolutionary forces like social, financial, judicial, and political institutions should be initiated right now to ensure that current intended actions against the defaulters do not become just an act to please big multilateral donors.

Interventions that directly address core problems of the institutional set up in our economy is necessary given the fragile state of our loss-making public institutions and the struggling private sector.  ‘Shallow’ intervention that addresses the economic issues from surface only is just a way of getting away with the rage of donors and the civil society for the time being. The government should go for ‘deep’ intervention that would address not only the issues related to current defaulters. The actions should also bring about a gradual change in our institutional arrangement in the economy. The first type of intervention is fickle and, as experienced in the past, is subject to discontinuity in the case of a change in government. The second form of intervention sets up social, financial, judicial, and political institutions in such a way that successive governments find it difficult to discontinue preceding reform agendas. So going for deep intervention to fine tune the institutional setting of our economy and the institutions that deal with defaulters should be carried out along with the present actions against the defaulters. Yes, these financial hooligans and criminals should be punished but we also need to be vigilant on the possible repercussions this might create in the fragile economy.

(Sapkota is studying in Dickinson College, USA)

Pakistan ’s Growth: Learning for Nepal

In recent years, Pakistan has been an example of economic success story. The GDP growth rate that was 3.11 percent in 2001-02 went up to 7.48 percent in 2003-04. The average growth rate has remained over seven percent for the last four years - quite enviable for Nepal which is struggling to maintain the growth rate at around 2 percent.

No doubt that Pakistan cannot be compared with Nepal as the latter had a much delayed start in modern economic development. However, there are some important lessons for Nepal to learn from what Pakistan did in the recent years, particularly after General Pervez Musharraf came to the power.

The basic economic agenda that Pakistan followed under the leadership of Gen. Musharraf can be summarized under three main points: widening the tax net, privatisation and improving the balance of trade. The World Bank has repeatedly praised Pakistan for being the top reformer in entire South Asia. To set the environment for the success of these agenda, Pakistan reduced tension with India, made governance reforms and privatized public utilities.

The result was massive inflow of foreign direct investment, which increased to more than US $ 3872 million in 2005-06 compared to less than US $ 475 million in 2001-02. The government debt was massive 82 percent of GDP in 2002. That reduced to 59 percent in 2005. The benefit was evident. While the Pakistan government was spending 35 percent of its annual revenue for interest payment in 2002, this figure reduced to 23 percent in 2005.

The savings from military spending by reducing the tension with India and the savings in the interest payment were channelised in development spending. In 1990s, Pakistan was spending only about 2 percent of GDP in development activities. That figure has increased to about 4 percent in recent years.

Export-led growth

One important feature of Pakistan’s policy departure in the recent years is the abandonment of the policy of import substitution. Rather the country has now embarked on a policy of export-led growth. For this purpose, it has spent heavily in improving the infrastructure like ports, roads and power supply. And the liberalization of the international textile trade after the expiry of Multi-fibre Agreement (MFA) has benefited Pakistan a lot. The large scale manufacturing sector’s growth rate was 10.7 percent in 2005-06 and the exports grew that year by 11.7 percent. The result is that the total foreign exchange reserve of the country reached US $ 13 billion in February 2006, a 12-fold increase over the figure of 2001. This is in spite of the fact that the growth rate in the imports was 19.5 percent, i.e. higher than the exports. One of the contributing factors was the increased inflow of remittance from Pakistanis working abroad, which is regarded as an indication of the growing confidence in the government.

But the sort of miracle achieved in sustaining a high rate of growth has two more factors behind it. One, the government of Pakistan has followed a consistent policy during these years, thus giving an assurance to the investors that they don’t have a risk of sudden policy changes in the future. That contrasts very significantly from Nepal where sudden policy changes are the norm of the day. Second, the management of the economy is entrusted in the hands of the professionals. The example is Prime Minister Shaukat Aziz, a veteran with long experience of working in the World Bank.

By Madan Lamsal

Federalism
The Legal Environment for doing Business

By Semanta Dahal

From an international business perspective, Nepal's competitive advantage lies in its hydro power, bio-diversity, tourism and strategic location. Though it is very early to sketch a map and suggest modalities for Nepal's federal structure, the Constituent Assembly, after election, will be transforming Nepal into a federation creating several states or provinces. This means Nepal's innate resources will be scattered resulting in some states being more favored than the others for business purpose. This is not only because of their being ecologically resourceful but also because of the comparative advantages which can be derived from the commercial laws.

Autonomy

In common parlance federalism is a power sharing mechanism between centre and state governments created constitutionally by dividing sovereignty and autonomy for effective administration. Usually the central authority is supreme, ultimate and strong and it unites the various state authorities, which enjoy autonomy vis-à-vis the centre and other state governments. This structure makes each state responsible for its defined boundary and also empowers them to legislate on areas of commerce and industries. There will be a diversity of laws within the country and business will need to operate in compliance with different legal standards and administrative practices.

Inter-State Competition

Each state's development will be measured in terms of job opportunities, incomes, business capital and investments, its gross domestic product etc. For this reason the states will have to create jobs and look for capital investments. This will lead to fierce competition just to keep and attract business and industries. The states will generate strategies and tactics to encourage growth and achieve their economic goals by inducing companies to bring in new businesses. For example, State A through which the East-West Highway runs, also has the vertical highway like the Sindhuli-Bardibas Highway connecting it to the hills. It offers tax breaks that outweigh benefits provided by State B, which is totally or mostly hilly. State A will attract most of the manufacturing industries. This may be offset suitably and favorably if State B has a sustaining tourism sector to run its economy. Else State B will lose out and its prosperity will be greatly hampered. Similarly, a hydro power company will like to invest in the State which has less stringent environmental laws for establishing a plant.

Attracting investors

It is very likely, that states with justifiable reasons to attract outside firms to start business can offer various tax incentives like exemption from corporate income tax, personal income tax, and research and development tax and they can also reduce the excise duty. Capital investment in a state will also depend upon non-tax factors including education, transportation, public safety, cost of living, cost of labor and environmental regulations. A businessman thus will be left with choices among the states to establish business in a scenario where all the states will be vying with each other to induce him to invest capital.

Trade & commerce

However, the questions may arise - Will it be beneficial if each state is allowed to enact laws freely and structure its tax system or impose tariffs on imports from another state? Will it be right to frame laws which may create a competitive business environment where it is foreseeable that there will be an unbalanced distribution of resources? Arguments favoring competition would insist that it will enhance state-wise governmental discipline that can produce effective commercial laws for innovations and finally for an overall development of the states. Also that if products manufactured in and services provided by one state are different or can be differentiated from those of the other states, then it is indeed important that the states be authorized to legislate.. On the other hand, arguments against competition would point out that because of discriminatory commercial laws, inter-state commerce will be hampered resulting in an asymmetrical development, which is harmful to Nepali society at large.

Regulating Commerce

Assenting to competitive commercial laws will not be easy in the context of Nepal where ensuring proper competition will be a difficult task. Without any uncertainty competition should be promoted for ensuring a sound environment for business, but it is also important that for a healthy competition some kind of regulation be in place. To create this environment, the authority for regulating inter-state commerce should be given to the central government so that uniform laws are enacted to govern commerce and business in Nepal. But if some states are favored for business because of exclusivity in resources and business opportunities in certain sectors, these states must be empowered to pass laws on those sectors if the laws are formulated only for the state's economic objectives and is not discriminatory in comparison with the other states' laws. Perhaps, in this way it can be assured that no state is unduly advantaged and that each state gets a fair opportunity to provide a sound environment for business.

Decentralisation

Since commitments are being made regularly by all concerned, the outlook for peace and real federal democracy dawning in Nepal is quite optimistic. Federalism is one of the decentralization processes, and a decentralization process can only be successful if gaupanchayats and jillaparishads can participate actively in the economy and development of the country. The Constituent Assembly will indeed deliberate on inclusive democracy, minority and ethnic groups and their rights while drafting a new constitution for Nepal, but it is also equally important that the constituent assembly while considering federalism intensely work towards drafting a constitution which would make entire Nepal an ideal place for doing business, so that "New Nepal" can thrive on its hydro power, bio-diversity, tourism and strategic location.