India - Third five year plan (Vol. 8 of 9) : Internal Finance

RESTRICTED Annex VII to Report No. AS-80a This report was prepared for use within the Bank. It may not be published nor may it be quoted as representing the Bank's views. The Bank accepts no responsibility for the accuracy or completeness of the contents of the report. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INDIA'S THIRD FIVE-YEAR PLAN REPORT OF BANK MISSION TO INDIA Annex VII INTERNAL FINANCE August 10, 1960 Department of Operations South Asia and Middle East CURRENCY EQUIVALENTS 1 Indian Rupee = U. S. $0. 21 1 U.S. Dollar = Rs. 4. 762 Rs. 1 billion = $210 million 100 Naye Paise = One Rupee TABLE OF CONTENTS Page No. (A) SOURCES OF FINANCE FOR THE SECOND PLAN Public Sector General 1 Balance from Current Revenues 5 Additional Taxation 7 Contribution of the Railways 11 Public Loans 13 Small Savings 14 Unfunded Debt and Miscellaneous Capital Receipts 16 External Resources 17 Deficit Financing 17 Private Sector 19 Money Supply and Prices 24 (B) SOURCES OF FINANCE FOR THE THIRD PLAN Public Sector General 27 Balance from Current Revenues 30 Contribution of Public Enterprises Railways 31 Other Public Enterprises 31 Additional Taxation 33 Public Loans 34 Small Savings 36 Unfunded Debt and Miscellaneous Receipts 36 External Resources 37 Deficit Financing 39 Private Sector 40 APPENDIX I Impact of PL 480 Surplus Goods Deliveries on Domestic Finance in India 42 APPENDIX II Some Notes on Taxation 48 TABLES IN TEXT Page No. 1. Sources of Finance for the First and Second Plans 2 2. Sources of Finance for the Second Plan by Years 3 3. Balance from Current Revenues 6 4. Revenue from Additional Taxation 8 5. Tax Revenue of Central and State Governments 10 6. Contribution of Railways to Financing of Plan Expenditure 11 7. Loans of Central and State Governments and Their Absorption 12 8. Net Collections from Small Savings 14 9. Subscriptions to Various Savings Schemes 16 10. Net Private Investment During the Second Plan 19 11. Financing of Private Industrial Investment During the Second Plan 20 12. Sources and Uses of Funds of Corporations 21 13. Gross Profits as Percentage of Total Net Assets Employed 22 14. Sources of Finance for the Second and Third Plans 28 ANNEX VII. INTERNAL FINANCE (A) SCURCES OF FINANCE FOR THE SECOND PLAN Public Sector General 1. Estimates of the various sources of finance for public expenditures under the Second Plan are shown for the total Plan period in Table 1; this table also gives the corresponding items for the First Plan. Table 2 sum- marizes the available information on sources of finance for the individual years of the Second Plan. Apart from the data provided to the mission by the Planning Commission, Tables 1 and 2 also show the results of estimates on a different conceptual basis made by the mission itself. These estimates were made because they are believed to be more revealing from the point of view of economic and monetary analysis. The major differences underlying the date of the Planning Commission and the estimates of the mission are as follows. 2. Whereas the amounts for public loans in the documents of the Planning Commission refer to the amounts raised by Central and State Govern- ments (net of repayments), the mission has tried to estimate the amounts that were in fact absorbed by the market exclusive of the central and commercial banks. Thus, while the Planning Commission gives a figure for public loans during the four-year period April 1956 - March 1960 of about Rs. 6.2 billion, the mission has arrived at an estimate for this period of about Rs. 2.2 billion, the difference of the order of Rs. 4 billion being explained by the absorption of government bonds by the Reserve Bank, the State Bank and the other commercial banks during the four-year period. Similarly, whereas the Planning Commission's estimate for five years is Rs. 8 billion, that of the mission is only Rs. 3 billion, the estimated absorption of bonds by the bank- ing system for the entire Plan period being about Rs. 5 billion. 3. The Planning Commission's figure of external resources available for Plan expenditure in the public sector is Rs. 6.2 billion during the four years 1956/57 - 195Q/60. This figure does not include the substantial amounts of rupees which have accrued to the Central Government from the sale of PL 480 commodities inside India, apart from the small amounts (less than Rs. 0.3 bil- lion) of PL 480 local currency that so far have been released by the U.S. authorities for spending on approved projects. Instead, the mission's esti- mate of external resources of Rs. 9.2 billion for the four-year period includes the full amount of local currency on account of PL 480 sales. The mission's estimate of external resources for 1960/61 and for the full five-year period (Rs. 3.9 billion and Rs. 13.1 billion respectively) rest on the same conceptual basis; admittedly they are no more than rough estimates. - 2 - Table 1. Sources of Finance for the First and Second Plans Rs. billion Per cent of Total Second Plan First Second Plan First Plan Plan Orig. Latest Esti- a/ Orig. Latest Esti- _/ esti- esti- mates Out- esti- esti- mates Out- mates mates based come mates mates based come (Plann. (Plann. on (Plann. (Plann. on Comm. Comm. mission Comm. Comm. mission defin.) defin.) defin. defin.) defin.) defin. Balance from current revenues at existing rates of taxation b/ 3.5 -1.0 -1.0) 7.3 -2.2 -2.2) ) 6.3 ) 32.1 Additional taxation 4.5 10.0 10.0) 9.4 21.7 21.7) Railways' contribution 1.5 1.5 1.5 1.2 3.1 3.3 3.3 6.1 Public loans (net) 7.0 8.0 3.0 c/ 2.0 14.6 17.4 6.5 10.2 Small savings 5.0 3.8 3.8 2.4 10.4 8.3 8.3 12.3 Unfunded debt and mis- cellaneous capital receipts 2.5 2.1 2.3 1.7 5.2 4.5 5.1 8.7 External resources d/ 8.0 9.8 13.1 1.9 16.7 21.3 28.5 9.7 Deficit financing 12.0 11.8 13.3 4.1 25.0 25.7 28.8 20.9 Gap to be covered by additional measures to raise domestic resources 4.0 - - 8. - - -- Total expenditure under Plan 86.0 46.0 19.6 100 100 100 100 a/ On the basis of Planning Commission definitions. b/ Rates of taxation existing during 1955/56; balance arrived at before taking into account additional taxation and current expenditures on development in- sofar as included in the Plan. c/ Excludes absorption of government bonds by Reserve Bank and commercial banks (including State Bank) to an amount of the order of Rs. 5 billion (see text). d/ Excluding the drawing down of foreign exchange reserves (see paragraphs 30-31 below). Table 2. Sources of finance for the Second Plan by Years (Rs. billion) 1956/57 1957/58 1958/59 1959/60 1956/60 1956/60 1960/61 1960/61 1956/61 1956/61 Estimates based on Estim. based on Estim. based on Estim, based on Planning Conmission definitions Plann. mission Plann. mission Plann. mission Comm. defin. Comm. defin. Comm. defin. defin. defin. defin. Balance from current revenues at existing rates of taxation a/ 0.90 0.21 -0.39 -0.72 - - -1.00 -1.00 -1.00 -1.00 Additional taxation 0.55 1.69 2.19 2.62 7.05 7.05 2.95 2.95 1000 10.00 Railways' contribution 0.33 0.29 0.23 0.31 1.16 1.16 0.34 0.34 1.50 1.50 Public loans (net) 1.39 0.73 2.26 1.78 6.16 2.20 b/ 1.8h 0.80 b/ 8.00 3.00 b/ Small savings 0.61 0.69 0.79 0.83 2.92 2.92 0.88 0.88 3.80 3.80 Unfunded debt and mis- cellaneous capital receipts -0.39 -0.69 1.37 1.30 1.59 1.ho c/ 0.54 0.95 c/ 2.13 2.35 c/ External resources d/ 0.42 0.91 2.17 2.67 6.20 9.20 3.62 3.90 9.82 13.10 Deficit financing 2.`3 4.96 1.36 1.27 10.12 11.25 1.63 2.00 11.75 13.25 Total expEnditure under Plan 6.34 8.82 9.98 10.06 35.20 35.20 10.80 10.80 h6.00 46.00 a/ Rates of taxation existing during 1955/56; balance arrived at before taking into account additional taxation and current expenditures on development included in the Plan. b/ Excludes absorption of government bonds by Reserve Bank and commercial banks (including State Bank). c/ Rounded figures. d/ Excluding the drawing down of foreign exchange reserves. 4. The figure of the Planning Commission for deficit financing (Rs. 10.1 billion for the four years 1956/57 - 1959/60) represents the amount of additional Treasury bills issued plus the decrease in cash balances of Central and State Governments. Instead, the mission has tried to approximate the amount of money creation due to Plan expenditures of Center and States; the result is an amount of the order of Rs. 11.25 billion. The mission's figure for deficit financing during 1960/61 (Rs. 2 billion) is based on the assumption that the amount will about equal that during 1959/60. The minor differences between the amounts shown by the Planning Commission and by the mission for the item "Unfunded Debt and Miscellaneous Capital Receipts" are of no real significance!/; this is a balancing item in the mission's esti- mates.2/ 5. The mission's definitions involve treating the increase in the portfolio of government bonds of the commercial banks as an element of deficit financing.S We believe this is appropriate because this increase gives rise to an increase in money supply.4/ Admittedly part of this creation of addi- tional money may be justified on account of the needs of the economy; but the same is true for other forms of money creation. Also, the increase in hold- ings of government bonds among assets of the banking system may be compensated by a rise in time deposits among liabilities (as has been the case in India); but the same argument can be used with respect to an increase in other assets of the banking system, such as bank advances to the private sector. 6. Tables 1 and 2 show that the reliance on external resources and deficit financing combined as resources for the Second Plan will have to be larger than anticipated originally, in spite of some shortfall in total spend- ing in the public sector compared to the original target. On the basis of the Planning Commission's definitions, external resources and deficit financing are to finance 47 per cent of the revised expenditure, against some 42 per cent of the higher original target. On the basis of the definitions under- lying the mission's estimates the total of both items goes up to an estimated 57 per cent. 1/ A small conceptual difference is that an amount of Rs. 0.05 billion received by the Central Government annually on account of an equivalent amount of rupee coin made available to the Reserve Bank has been treated as deficit financing, whereas it is included among miscellaneous capital receipts in the Planning Commission documents. / To the extent that the somewhat higher mission estimate for 1960/61 of this item would turn out to be unrealistic one of the other items (presumably deficit financing) would have to rise correspondingly (unless there would be some shortfall in total expenditure). / The major share of the increase in holdings of government securities by the State Bank did not on balance give rise to deficit financing, since there was a money-decreasing offset through the sale of PL 480 commodities inside India (see paragraph 44). / It is important to realize in this connection that cash held by banks (in- cluding balances of banks with the central bank) do not form part of a country's money supply. -5- 7. The increased reliance on the two sources just mentioned has its counterpart in a shortfall, compared to targets, of domestic sources of finance as a whole (other than deficit financing). On the plus side addi- tional taxation will bring in more than originally expected (even if one includes in the target the financing "gap" in the original Plan). On the minus side, current government expenditure outside the Plan has gone up more than current revenue (apart from additional taxation), and revenue from small savings remains well below the target. Proceeds from public loans will exceed the target on the basis of the Planning Commission's figures, but on the basis of the mission's figures there is a big shortfall. 8. If one compares the pattern of resources mobilized to finance public expenditure under the Second Plan with that under the First Plan, the most important change is the rise in importance of external resources and deficit financing. On the basis of the data of the Planning Commission the amounts obtained from these two sources combined will go up by Rs. 15.6 billion (260 per cent) compared with an increase for all other (domestic) financial re- sources together of Rs. 10.8 billion (almost 80 per cent). If one accepts the mission estimates, these figures are Rs. 20.5 billion (about 340 per cent) and Rs. 5.9 billion (almost 45 per cent) respectively. The individual sources of finance for public expenditures under the Second plan will be examined in more detail in the sections that follow. Balance from Current Revenues 9. The current budgetary resources available for the financing of expenditures in the public sector of the Second Plan consist of the balance from current revenues at rates of taxation existing prior to the start of the Plan (i.e. during 1955/56) and revenue from additional taxation introduced during the course of the Second Plan. The balance from current revenues is discussed in this section and additional taxation in the next section. 10. As mentioned already, budgetary results during the Second Plan period have been less favorable than anticipated when the original estimates of resources for the Plan were made, giving rise to an anticipated shortfall of current revenue below non-Plan expenditures of Rs. 1 billion, at 1955/56 rates of taxation, instead of an originally estimated surplus of Rs. 3.5 billion. Table 3 shows in some detail how the deterioration by Rs. 4.5 billion compared to the initial target has come about. While comparing the estimates, some special factors which limit the comparability should be kept in mind. When the initial estimate of the balance from current revenues available for the Second Plan was made, it was intended not so much to arrive at the absolute totals of receipts and expenditures as to form an idea of the available balance. Transfers between the revenue and capital accounts were not gone into in detail, since they did not affect the overall picture of resources. For this reason the item "Transfers to Capital Account" (Rs. 1.44 billion) should be eliminated for purposes of comparison. Also the initial estimates of receipts and expenditures were made at constant prices. Other circum- stances which make the large difference between the most recent and the initial estimates understandable are the length of the total period for which estimates were made and the large number of spending authorities at the Center and in the States. Table_2. Balance from Current Revenues (Rs. billion) Latest Estimates for Difference estimates original Second Plan I. Current revenues at 1955/56 rates of taxation 58.75 50,00 II. Non-Plan expenditures (a) Non-develooment exenditures Civil administration, police, jails and justice 9.41 7.92 1.49 Tax collection 3.41 2.63 0.78 Defense a/ 13.60 11.81 1.79 Debt service 6.53 4.44 2.09 Currency and mint 0.41 0.19 0.22 Transfers to capital account b/ 1.44 - 1.44 Miscellaneous 5.95 3.91 2.04 Total 40.75 30.90 9.85 (b) Development expendi- tures 19.01 15.60 _.41 (c) Total (a + b) 59.76 46.50 15.26 III. Balance from current revenues at 1955/56 rates of taxation -1.01 3.50 a/ Includes capital expenditures on defense (Rs. 1.45 and Rs. 1.37 billion for latest and original estimates respectively). b/ Includes surcharge on iron and steel (transferred to Iron and Steel Equalization Fund), sale proceeds of evacuee property and PL 480 grants. - 7 - 11. The fact remains that the rise since 1956/57 in expenditures at the Center and in the States has been substantial for a number of cate- gories of non-Plan expenditures, both in absolute terms and in relation to the initial estimates (which themselves implied some rise during the Second Plan). The rise of some of these expenditures, particularly on defense and debt services, was obviously difficult to avoid. For a substantial part of the increases in other important categories of expenditures convincing arguments have been advanced, including price increases, unavoidable adjust- merits in salaries of low-paid employees and necessary increases in staff in connection with the preparation and execution of Plan activities. On the other hand, some of the criticism heard in the country that a closer and earlier scrutiny of expenditure would have resulted in economies is presum- ably justified. An implicit recognition of the correctness of this view can be found in the one year ban (imposed recently) on recruitment to all posts which are not connected with the Plan or which are not required for security purposes. It should be added that the Central Government has shown an increasing awareness of the necessity to slow down the rise in current public expenditures. Since 1957 all Ministries and Departments have set up internal Economy Committees; the implementation of the economy measures is supervised by a Central Economy Board, which also guides and supervises the work of an Economy Unit of the Ministry of Finance. The mission was told during its visit that in a number of instances the economy drive has already brought encouraging results. Additional Taxation 12. The amount of financial resources mobilized by means of new measures of taxation introduced during the period of the Second Plan is now estimated to be almost Rs. 10 billion, of which slightly less than Rs. 8 billion will be raised by the Central Government and a little over Rs. 2 billion by the States. The total additional tax effort compares favorably with the target in the original Second Plan. The Plan foresaw additional tax measures of no more than Rs. 8.5 billion (consisting of a target figure of Rs. 4.5 billion plus the "gap" in resources in the Plan of Rs. 4 billion, which was also intended to be covered through a stepping up of the fiscal effort). Since about half of the Plan target figure in the narrow sense (Rs. 4.5 billion) had been allocated to the Center and half to the States, it can be seen in retrospect that the Center has been much more successful than the States in raising additional taxation. In connection with the amounts raised through additional taxes, it should be borne in mind that total revenue from the taxes in existence at the beginning of the Second Plan turned out to be only slightly responsive to the rise in national income during the Second Plan period (see below), and that almost half of the revenue from additional taxes was eaten up by the growth in non-Plan expenditure. - 8 :-. Table 4. Revenue from Additional Taxation (Rs. million; cumulative) 1956/57 1957/58 1958/59 1959/60 1960/61 1956/61 (Rev.Est.)(Bud g_Est.)(Total) Central Government Income tax 64 160 131 156 220 731 Health tax - 70 96 120 70 356 Expenditure tax - - 6 8 9 23 Gift tax - - 10 8 9 27 Railway passenger tax - 37 122 126 127 412 Customs duties 20 90 90 90 115 405 Excises a/ 349 1.108 1.1 53 L 47S 1 7823 Total 433 1,465 1,608 1,96 7,80 State Governments General sales taxes 62 197 276 301 321 1,157 Excises 3 5 8 9 10 35 Agricultural income tax - 8 21 25 26 80 Land revenue 4 15 24 24 33 100 Betterment levies - - 4 10 12 26 Electricity duties 7 11 29 24 23 94 Taxes on motor vehicles, bus fares and freights 34 46 70 108 114 372 Sales tax on motor spirits and diesel oil 3 7 24 25 27 86 Stamp duties and registration - 4 12 21 21 58 Other duties 2 14 24 34 40 114 Total b/ 115 307 492 581 627 2,122 Total Central and State Governments 548 1,772 2,100 2,567 2,915 9,902 a/ Excludes the yield from additional excise duties on sugar, tobacco and mill-made textiles levied in replacement of States' sales taxes. b/ Excludes revenue from increase in postal rates (Rs. 98 million during 1956/61), being non-tax revenue. - 9 - 13. Table 4 sets out in detail the contribution of individual taxes to the increased fiscal effort. Some 86 per cent (Rs. 8.56 billion) of total revenue raised through additional taxes is expected to come from in- direct taxes. Of this, additional excises levied at the Center account for the major share (Rs. 5.83 billion), followed by general sales taxes levied by the States (Rs. 1.16 billion). A number of new commodities have been brought within the scope of Union excises, and rates of existing excises and sales taxes have been stepped up. Additional excise duties have been levied on sugar, tobacco and mill-made textiles in replacement of States'sales taxes. The three other major contributors to additional revenue in the field of in- direct taxes are customs at the Center (Rs. 0.41 billion); the new tax on railway passenger fares introduced in 1957 which is levied by the Center, but the proceeds of which are transferred to the States (Rs. 0.41 billion); and taxes on motor vehicles, bus fares and freights (Rs. 0.37 billion). Taxes on bus fares and freights are at present levied in nine States, as against four States in 1955/56. 14. Additional measures in the field of direct taxation are expected to bring in about 14 per cent (Rs. 1.34 billion) of total additional taxes. The most important contribution (Rs. 0.73 billion) will come from the Central income (including corporation) tax. The exemption limit for personal income taxation was lowered from Rs. 4,200 to Rs. 3,000 with effect from 1957/58. Other increases in income taxation at the Center involved incomes of regis- tered partnerships, business incomes of cooperatives, bonus issues and capital gains. Rs. 0.36 billion will be raised from the new wealth tax, levied with effect from 1957/58. Other measures of additional direct taxa- tion at the Center (of minor budgetary importance) have been a gift tax (on gifts inter vivos) and an expenditure tax, both levied since 1958/59. The States have also collected some more revenue from direct taxes, although the total amounts are relatively small. Agricultural income taxation has been extended to more States and the rates of the levy stepped up. A few States have imposed betterment levies and surcharges on land revenue. 15. The Indian tax system is still characterized by a preponderant reliance on indirect taxes (about two thirds of the total). The new measures of taxation introduced during the Second Plan have not changed this situation. However, it appears that some of the changes in direct as well as indirect taxation have made the system distinctly more responsive to increases in national income. This has indeed been one of the principal aims of taxa- tion policy. For example, increasing attention has been given to taxing articles of mass consumption such as cloth, sugar and vegetable oils. In 1953/54 about 3 per cent of per capita consumers' expenditure on mill-made cloth was accounted for by Central excise duties; in 1958/59 the proportion was about 9 per cent. The incidence of Central excise duties on sugar, calcu- lated on the same basis, rose from 18 per cent in 1953/54 to 42 per cent in 1958/59. 16. In Table 5, tax revenue of both the Central and State Governments is shown, subdivided into revenue from tax legislation existing during the last year of the First Plan (1955/56) and revenue from additional measures of taxation introduced during the Second Plan. The table brings out that the former category has been little responsive to the rise in national income - 10 - which has occurred during the Second Plan period, particularly at the Center. Against this, the estimated share of additional taxes in total tax revenue has risen correspondingly during the individual years of the Second Plan. The table also shows total tax revenue as a percentage of national income. Not too much importance should be attached to variations in this percentage from year to year. Yearly variations in crops, which affect the national income figures strongly, cannot be expected to give rise to corresponding changes in tax revenue. Nevertheless, the figures appear to indicate that the share of national income taken by taxes levied by Center plus States has gone up during the Second Plan period. Table 5. Tax Revenue of Central and State Governments (Rs. billion) 1950/51 1955/56 1956/57 1957/58 1958/59 1952A .96o/6I Central Government (1) "Existing" taxationc/ 5.30 5.49 5.54 5.83 5.91 (2) "Additional" taxation / 0.43 1.47 1.61 1.99 2.29 (3) Total tax revenue e/ 4.05 4.85 5.73 6.96 7.15 7.82 8.20 (4) (2) as % of (3) 8 21 23 25 28 State Governments (5) "Existing" taxation/ 2.76 3.19 3.23 3.23 3.48 (6) "Additional" taxationd./ 0.12 0.31 0.49 0.58 0.63 (7) Total tax revenue f/ 2.21 2.76 2.88 3.50 3.72 3.81 4.11 (8) (6) as % of (7) 4 9 13 15 15 Center and State (9) Total tax revenue 6.26 7,61 8.61 10.46 10.87 11.63 12.31 (10) National income g/ 95.3 99.8 113.1 114.0 124.7 h/ (11) (9) as % of (10) 6.6 7.6 7.6 9.2 8.7 a/ Revised estimates. b/ Budget estimates. / Revenue exclusive of that from measures of taxation introduced during the period of the Second Plan. d/ Revenue from measures of taxation introduced during the period of the Second Plan (cumulative). e/ Gross, i.e. including the share of States. f/ Figures are subject to minor differences in coverage due to reorganization of States. g/ Net national product at factor cost. h/ Preliminary. - 11 - Contribution of the Railways 17. The contribution of the railways to the financing of its investment expenditures under the Second Plan is estimated at Rs. 1.50 billion, which is the same as the original target. Table 6 shows the composition of this total. "Open Line Works" charged to Revenue are expenditures of a capital nature which appear in the Revenue Account of the railways; the "Net Surplus" repre- sents the railways' net profit (after depreciation and payment of dividend to the Central Government) and the "Interest on Fund Balances" is the income earned on balances held by the railways. Apart from the contribution of the railways in a narrow sense, as shown in the table, the railways pay yearly dividends to the Central Government. The total of dividends for the period of the Second Plan will be about Rs. 2.45 billion. Adding this to the Rs. 1.50 billion, the contribution of the railways in a wider sense of Rs. 3.95 billion compares to a latest figure for net investment by the railways during the Second Plan of about Rs. 8.96 billion. Besides, the railways expect to set aside for depreciation Rs. 2.25 billion (Rs. 0.45 billion annually) during the current P an. Estimated total gross investment during the Plan is Rs. 11.21 billion. ] Table 6. Contribution of Railways to Financing of Plan Expenditure (Rs. billion) 1956/57 1957/58 195/52 1959/60 1960/61 19 6 Accounts Accounts Accounts Rev.Est. Budg.Fst. Total Open line works charges to revenue 0.08 0.10 0.11 0.14 0.14 0.57 Net surplus 0.20 0.13 0.09 0.15 0.18 0.76 Interest on fund balances 0.05 0.05 0.03 0.02 0.02 0.17 0.33 0.29 0.23 0.31 0.34 1.50 17 This division between gross and net railway investment-i.e., Rs. 11.21 billion gross, Rs. 8.96 net-is that used by the Planning Commission. The Railway Board now estimates its replacement expenditures during the Second Plan at Rs. 3.20 billion, of which Rs. 2.25 billion will be financed through current provision for depreciation and Rs. 0.95 billi6n through drawings on depreciation reserves. On this basis net investment during the Plan would be only Rs. 8.01 billion, and the amount of total Plan expenditures would be nearly Rs. 1 billion less than the Rs. 46 billion now estimated by the Planning Commission. - 12 - Fublic Loans 18. The amounts raised through public loans during the first four years of the Second Plan are shown in Table 7. For purposes of comparison the table also gives the corresponding amounts raised during the First 7lan period. The first column of the table gives the amounts of initial subscrip- tions to the various loans of the Central and State Governments at the time of issue. The next two columns give a breakdown of initial subscriptions between the "public" (i.e. all investors other than the Reserve Bank and the Central and State Governments themselves) and the Reserve Bank plus Govern- ments. Column (2) gives only a very imperfect picture of the amounts of government bonds that were in fact absorbed by the public in various years. A varying proportion of new public loans is absorbed initially by the Reserve Bank and the Central and State Governments. (There is very little Reserve Bank subscription to State Government loans, and initial subscriptions of Governments are also known to have been small during the last few years). In the course of the year the Reserve Bank buys and sells government bonds in the open market apart from its initial subscriptions; similar transactions are undertaken by the Central and State Governments, but they have been small during the last few years. The Reserve Bank is thus able to contribute to a stabilization of market conditions and satisfy the demand of those investors which require securities practically throughout the year (e.g. provident funds). Column (4) of Table 7 shows the amounts of open market sales to the public by the Reserve Bank (and Central Government) and Column (6) the total net absorp- tion of government securities b. the public on account of initial subscriptions and net market purchases combined. 19. The original target for public loans during the Second Plan was Rs. 7 billion (Rs. 1.40 billion per year on average) and the latest estimate is Rs. 8 billion (Rs. 1.60 billion per year). Initial subscriptions to loans during the first four years of the current Plan have been about Rs. 1.53 billion yearly (Column (1) of the table), but net amounts absorbed by others than the Reserve Bank and Central Government no more than Rs. 1.30 billion annually (Column (6)). Moreover, the last-mentioned amount includes substantial investments in government securities by the State Bank of India on account of PL 480 local currency deposited by the U.S. Government with this Bank. Exact data on investments by the State Bank in government securities are not avail- able, but an amount of Es. 0.50 billion yearly would seem to represent the correct order of magnitude. This leaves a yearly average of about Rs. 0.80 billion for the net absorption of government securities by the public exclusive of the State Bank during the first four years of the Second Plan. The figure of Es. 0.80 billion includes the increase in holdings of the commercial banks (other than the State Bank). Investments of these banks in government bonds rose by almost Rs. 1 billion during the first four years of the current Plan, i.e. by almost Rs. 0.25 billion annually. Consequently the average net absorption of government bonds by the public exclusive of commercial banks will have been of the order of Rs. 0.55 billion yearly. 20. The conclusion emerging from the preceding analysis is that, if one eliminates the special purchases of the State Bank (representing the counter- part of the inflow of foreign assistance), the amounts of government loans - 13 - Table 7. Loans of Central and State Governments and Their Absorption (Rs. billion) Net market borrowings by Central Net sales in Total not Total net and State Governments open market absorp- absorp- by Res.Bank tion by tion by Net receipts Absorbed by Absorbed by d/ Ras.Bank public by Govts. a/ public b/ Res.Bankr/ _/ (1)=(2)+(3) (2) (3) (4) (5)=(3)-(4) (6)=(2) +(A First Plan 1951/52 -0.25 +0.02 -0.27 -0.11 -0.15 -0.10 1952/53 +0.13 +0.13 - 40.21 -0.21 40.33 1953/54 -0.04 +0.46 -0.50 +0.34 -0.84 40.81 1954/55 +1.11 +0.67 +0.44 40.25 40.18 +0.93 1955/56 40.82 +o.64 40.18 40.29 -0.11 40.93 Total +1.77 +1.92 -0.15 40.98 -1.13 +2.90 Second Plan 1956/57 +1.41 +0.90 +0.51 -0.19 +0.70 40.71 1957/58 +0.71 +0.28 +0.43 +0.85 -0.43 +1.13 1958/59 +2.27 +1.06 +1.21 +0.89 40.32 +1.95 1959/60 +1.76 40o.83 --9 +0.61 40.33 +1.43 Total 46.14 +3.06 +3_08 +2.16 +F.c2 52 a/ Figures in this column differ somewhat from those for public loans in Tables 1 and 2, which are Planning Commission data. b/ The term "public" in this table includes all investors other than the Reserve Bank and the Central and State Governments. c/ Including amounts absorbed initially by Central and State Governments them- selves. d/ Including transactions by the Central Government itself. e/ The amounts in this column include investments in government bonds by the State Bank of India on account of PL 480 local currency accruals; they do not take into account net sales by State Governments themselves, the Reserve Bank's transactions in State Government loans and repayment of State loans held by State Governments. - 14 - absorbed by the public during the first four years of the Second Plan have equalled no more then some 55-60 per cent of the original yearly target for public loans or 50 per cent of the revised target, Exclusive of all commer- cial bank transactions, the performance has presumably been about 40 per cent and 35 per cent respectively. Small Savings 21. The original target for small savings during the Second Plan was Rs. 5.0 billion (an average of Rs. 1.0 billion a year). The latest estimate of realizations is Rs. 3.8 billion (Rs. 0.76 billion per annum). Collections have been raised to a level above that reached by the end of the First Plan, but not to the extent anticipated initially. Collections during 1956/57 were somewhat smaller than during 1955/56. Realization figures for the first four years of the current Plan and the years of the First Plan, together with the latest estimate for the fiscal year 1960/61, are shown in Table 8. Table 8. Net Collections from Small Savings (Es. billion) 1951/52 0.39 1956/57 0.61 1952/53 0.40 1957/58 0.70 1953/54 0.38 1958/59 0.79 1954/55 0.55 1959/60 0.83 a/ 1955/56 0.68 1960/61 0.88 b Total 2.40 Total .80 a/ Provisional. b/ Latest estimate. 22. Various measures were taken during the Second Plan to intensify the small savings campaign. They included: (a) an increase in interest rates on various forms of small savings since June 1957; (b) the introduction of two additional savings schemes, viz. cumulative time deposits (since January 1959, intended for those who have regular incomes and wish to invest their savings regularly every month) and prize bonds (since April 1960); - 15 - (c) an increase in attractiveness of existing schemes by such measures as a new payroll savings scheme (enabling voluntary deductions from wages at the source), easing of deposit and withdrawal facilities of postal savings banks, introduction of gift coupons exchangeable for plan savings certificates, rais- ing of maximum limits of holdings and possibility of transfer of small savings certificates to banks, etc., as security for loans; (d) strengthening of the organizational framework, one of the pur- poses being to extend the savings movement to the semi-urban and rural areas; and (e) increase in the share of collections to be retained by States. This share was raised gradually and since 1958/59 amounts to two thirds (for prize bonds one half). It is made available by the Centre in the form of loans for 10 years at 4 per cent per annum (in the case of prize bonds loans for five years at 3-5/8 per cent). 23. Small savings are now available under six schemes: (a) post office savings banks deposits (interest 2-21 per cent per annum, depending on amount deposited and category of holder); (b) cumulative time deposits (for 5 or 10 years; compound interest about 3.3 per cent for a 5-year account and 3.8 per cent for a 10-year account); (c) national plan savings certificates (12 years; compound interest 4.25 per cent); (d) Treasury savings deposit certificates (10 years; interest 4 per cent per annum); (e) annuity certificates (monthly repayments for a period of 15 years take place against an initial investment; compound interest 4.25 per cent); and (f) prize bonds (repayable at par after 5 years; bearer bonds in two denominations of Rs. 100 and Rs. 5; quarterly prizes instead of interest). The yield on the various kinds of small savings is free of income tax up to prescribed limits. The maximum that an individual can now invest in the various savings schemes combined is Rs. 105,000; this ceiling is exclusive of prize bonds, for which there is no limit. Subscriptions to the various sav- ings schemes since 1955/56 are shown in Table 9. As will be seen, additional post office savings bank deposits have fallen since the last year of the First Plan. The savings performance in the various States has been very uneven so far. Bombay State alone accounted for almost 30 per cent of net collections during the first four years of the Second Plan, followed by West Bengal and Uttar Pradesh (about 12 per cent each) and Bihar and Punjab (8-9 per cent each). - 16 - Table 9. Subscriptions to Various Savings Schemes (Rs. mil2ion) 1955/56 1956/57 1957/58 1958/59 1959/60iV Post office savings bank 370 313 180 202 198 Cumulative time deposits - - - 1 7 National plan savings certificates b/ 283 280 469 534 436 Treasury savings deposit certificates 41 30 51 53 94 Annuity certificates 4 4 6 5 5 Gross collections 697 627 706 795 740 Repayments 13 12 10 10 7 Net collections 684 615 696 785 733 Q a/ Provisional data which are substantially too low; total net collections for 1959/60 are now estimated at about Rs. 830 million. b/ Before June 1957 national savings certificates and national plan certificates (since discontinued). Unfanded Debt and Miscellaneous Capital Receipts 24. The original forecast for this item during the Second Plan was Rs. 2.5 billion. The Plan document explained that receipts of Rs. 1.50 billion were assumed on account of net accumula-i.ons b: provident funds . of Center and States, and that the remaining Rs. 1 billion represented recoveries of loans made by the Center and the Sates and miscellaneous capital receipts. The latest estimate for unfunded debt plus miscellaneous capital receipts is Rs. 2.1 billion, of which about Rs. 0.5 billion is expected to accrue during the current fiscal year 1960/61. The item as a whole is exceedingly variable, making estimates even at short term rather conjectural. This is explained by the fact that in the list of resources for the financing of the Plan this item is ,ore or less a residual, con- sisting of a heterogeneous group of budgetary debit and credit entries on capital account. - 17 - External Resources 25. Items included under this headinr represent the budgetary receipts on account of foreign loans and grants. As mentioned earlier (parapraph 3 above), assistance received under FL 480 is only entered here by the Planning Commission insofar as releases from the local currency account for spending on approved projects are cotcerned. In fact, the amounts of rupees that have accrued to the Government of India from sales of PL 480 commodities will have been roushly Rs. 3 billion larger than the releases for approved projects during the first four years of the Second Plan. This explains the difference in Table 2 between the mission's figure for external resources in the period 1956/57 - 1959/60 (Rs. 9.20 billion) and the Planning Com- mission's fiaure (Rs. 6.20 billion). The budget of the Central Government for 1960/61 includes releases of Rs. 0.8 billion (of which Rs. 0.7 billion by way of loans and Rs. 0.1 billion as grants). The amounts that will actually accrue on account of sales of PL 480 commodities will presumably be hip-her, and this assumption underlies the missionls estimate for external resources of about Rs. 3.90 billion durinR 1960/61 (as compared with the Planning Co-mission's figure of Rs. 3.62 billion). The various items of external assistance are discussed in Annex VI of this Report. Deficit Financing 26. The term deficit financing, as used in the documents of the Indian Planning Commission, refers to the sum of the increase in Treasury Bills outstanding and the drawing down of cash balances by Central and State Gov- ernments. The first item includes Treasury Bills placed by the Central Government with the Reserve Bank which were subsequently converted into special long-term government bonds held by the Reserve Bank. (Two trans- actions of this nature have taken place so far, one involving an amount of Rs. 3 billion in July 1958 and another of Rs. 1.5 billion in December, 1959). Deficit financing on the basis of this definition has amounted to Rs. 10.12 billion during the first four years of the Second Plan, and the latest esti- mate for the whole period of the Plan is Rs. 11.75 billion (see Table 2). It was hiohest during 1956/57 and 1957/8 (Rs. 2.53 and Rs. !.96 billion respectively) and has been substantially lower since. 27. The definition of deficit financing used by the Planning Commission is not very-useful for the purpose of monetary analysis. To this end it is more meaningful to define deficit financing as the amount of money created by or on behalf of Central plus State Governments. Calculations on the basis of this definition are now being made by both the Reserve Bank and the Min- istry of Finance. In the context of this definition the major relevant items are: (a) net increase in government securities (both Treasury Bills and long-term bonds) held by the Reserve Bank and the commercial banks and (b) net drawing down of cash balances by Central and State Governments. The definition we have adopted is wider than the traditional one in the sense that it includes the net absorption of long-term government bonds by central and commercial banks; it is on the other hand narrower in that it includes - 18 - only Treasur- Bills absorbed by the banking system and not the total increase in Treasury Bills outstanding. 1 28. Calculations on the basis of the revised definition, the results of which are shown in the Statistical Appendix, Table 15, give a total of deficit financing during April 1956 - M14arch 1960 of Rs. 11.25 billion. The picture for individual years is broadly similar to that on the basis of the Planning Commission's definition, 1956/57 and 1957/58 showing the highest anounts of Rs. 2.61 and Rs. 4.04 billion respectively. 29. In calculating the amounts of deficit financing deductions have been made in order to eliminate the effect of the special sales of Treasury Bills by the Government of India to the Reserve Bank in connection with the various PL 480 agreements. These special sales prorided the Government with rupees which - in partial fulfilment of the obligations of these agreements - had to be transferred to a special account held by the U.S. authorities with the State Bank of India. The deductions are appropriate since the special sales of Treasury Bills here referred to did not entail an increase of the amount of money in the economy. (For further details reference is made to Appendix I of this annex, which contains a technical note on "Impact of PL 480 Surplus Goods Deliveries on Domestic Finance in India" and to the footnotes to Statistical Appendix, Tables 14 and 15). 30. The figure of Rs. 11.25 billion for 1956/57 - 1959/60 implies that the full recourse by Governments to the Reserve Bank has been considered as deficit financing. This treatment, which has been followed throughout this annex, admittedly ignores the fact that part of this recourse served to pay for government imports needed to carry out the Plan. To the extent that 6his happened, there was on balance no increase in the countryts money supply. One can argue, therefore, that deficit financing has been lower and the amount of external resources that accrued to the public sector for financing of the Plan correspondingly higher. An exact calculation cannot be made, since the relevant data are not readily available. In Table 7 of the Main Report the estimated fall in external reserves during the whole Second Plan period (Rs. 5.6 billion) has been deducted fully from the "gross" amount of deficit financing for the entire Plan period (Rs. 13.3 billion), leaving a "net" deficit financing figure of only Rs. 7.7 billion. 31. When one wishes to emphasize the implications for domestic finan- cial policy, the method adopted in this annex seems preferable. If on the other hand one wishes to put the emphasis on total external resources needed for the financing of Plan expenditure, the method of presentation used in the ain Report seems appropriate. Neither of the tuo methods is in fact wholly satisfactory from a technical viewpoint. Whereas the gross deficit financing concapt, as used in this annex, may give rise to a somewhat too unfavorable 1/ Holdings of Treasury Bills by the banking system were 86 per cent of total Treasury Bills outstanding at the end of 1959/60, of which the Reserve Bank held 79 per cent and the cormiercial banks only 7 per cent. The remaining 14 per cent were helc; largely by State Governments. - 19 - impression ab-out the impact of government transactions on the money supply, the net concept, as just explained, may have the opposite effect. For an unknown portion of the fall in foreign reserves was not directly related to Plan expenditures in the public sector. It should also be noted that the presently estimated fall in external reserves of Rs. 5.6 billion during the Second Plan period is substantially larger than the Rs. 2 billion originally anticipated. Private Sector 32. Information about priv&te investment and its financing is much more fra6mentary than that with respect to public investment. Table 10 shows the original and latest estimtes for net private investment during the Second Plan broken down by major categories. Table 10. Net Private Investment during the Second Plan (Rs. billion) Original Latest estimates estimates a/ Agriculture (incl. irrigation) 2.75 6.75 Power 0.40 0.40 Transport 0.85 1.35 Village and small-scale industries 1.00 2.25 Large and medium-scale industries and minerals 5.75 7.00 Housing and other construction 9.25 10.00 Inventories 4.oo 5.25 Total 24.00 33.00 a/ Based on recent studies made by the Reserve Bank. The fi,ures in this column are not strictly comparable to the original estimates because the basis has been revised. b/ This amount includes a sum of Rs. 2 billion corresponding to transfers from the public sector for capital formation in the private sector. The Rs. 2 billion are a part of the latest estimate for spending in the public sector of the Second Plan, i.e. Rs. 46 billion. - 20 - 33. For the three most important sectors (housing and other construc- tion, industry and agriculture) information about finance is most complete for the industrial sector, notably for the large and medium-scale industries (the so-called organized sector). Table 11 summarizes the latest estimates for this sector. More detailed information concerning the financial structure of a representative sample of largely industrial corporations is available on the basis of data now collected regularly by the Reserve Bank for 1,000 public limited corporations; some of this information has been used in com- piling Table 12. Table 11. Financing of Private Industrial Investment during the Second Plan Rs. billion Per cent Institutional agencies 0.85 10 Direct loans and participation by Central and State Governments 0.20 2 New issues 1.20 15 Internal resources (net of repayment liabilities) 4.00 49 Direct foreign credits and partici- pations in capital 2.00 24 Total 8.25 a/ 100 a/ Includes expenditures on modernization and equipment (Rs. 1.25 billion), but excludes investment in inventories. 34. Both Tables 11 and 12 show that the role played by internal reserves in the financing of manufacturing industry in India is a modest one. Whereas during 1951-1955 Vheadition to internal resources (i.e. retained profits plus depreciation) corresponded on average to almost 60% of the increase in total assets, this percentage went down to well below 50 in 1956-1958. In the unfavorable year 1957 it hardly exceeded 25. These per- centages imply that, at least for the time being, profits have not been able to keep pace with the rising need for funds to finance industrial expansion under the Second Plan. Whatever the reasons for this situation, the mission feels that it would be desirable that the extent of self-financing in Indian industry should grow. International comparisons in this field are hazardous, but in many advanced industrial countries self-financing seems to be more important than in India. If countries with highly developed capital markets rely to a larger extent on self-finance for industrial capital, it seems - 21 - improbable that India, whose capital market is still quite limited, can get the growth of industrial investment she needs without a fairly sharp increase in the amount of internal savings within her larger manufacturing and service enterprises. Table 12. Sources and Uses of Funds of Corporations 1951/55 1956 1957 1958 Number of corporations a 750 1,001 1,001 775 Sources of Funds (percentages) Internal sources (retained profits plus depreciation) 59.9 37.0 27.6 46.5 Capital raised from market b 8.5 8.0 11.3 15.5 Credits from commercial banks 6.0 25.2 20.5 6.3 Other sources .2/ 25.6 29.8 4o.6 31.7 Total external scurces 40.1 63.0 72.4 53.5 Total rise of liabilities 100.0 100.0 100.0 100.0 Uses of Funds (percentages) Fixed assets 61.3 52.2 73.7 89.3 Inventories 13.8 35.0 21.8 2.8 Liquid and other assets 24.9 12.8 4.5 7.9 Total rise of assets 100.0 100.0 100.0 100.0 a/ The sample of 750 companies accounted for about two thirds of the paid-up capital of the sectors covered. The coverage of the sauple of 1,001 com- panies is about three fourths. The data for 775 companies for 1958 cover 83 per cent of the paid-up capital of the 1,001 companies. The years in the table refer to the accounting years of companies that ended during a period of twelve months commencing from July 1 of the year showm. b/ Including debentures. c/ Includes borrowing from industrial finance corporations and IBRD, mort- gages, trade dues, etc. - 22 - 35. Data on profits in various industries in India (also available on the basis of the enquiries into company finances by the Reserve Bank) show that profit levels have tended to be low in recent years. Gross profits (including managigagentst remuneration, all interest charges and provision for tax, but excluding depreciation), as a percentage of total not assets employed, averaged only about 7. per cent in 1957, the most recent year for which complete data are available (see Table 13). Althoug h 1957 was an un- favorable year and some rise in profits has occurred since, they have remained relatively low. Table 13. Gross Profits as Percentage of Total Net Assets Employed Average for Industry 1951-55 1955 1956 1957 Cotton textiles 8.2 11.6 9.7 3.4 Cement 13.8 13.9 10.3 8.0 Iron and steel 15.1 16.2 11.7 6.8 Paper 12.2 12.0 1o.4 9.4 Chemicals 4.8 7.0 7.1 7.6 Coal 8.3 8.9 6.2 8.5 All industry a/ 9.2 10.2 9.5 7. a/ Based on a sample of 1,001 companies, except for 1951-55, when only 750 companies were covered. 36. The Indian tax system contains a number of provisions aimed at the promotion of self-financing. New industrial unciertakinLs are exempt from tax on their profits up to 6 per cent of the capital enployed for a period of five years. A development rebate enables companies to deduct 25 per cent of the value of any new productive asset against profits in any one year or over a number of ye!rs. Provision is also mde for carrying forward losses (generally for a period of eight years) as an offset against profits. 37. The mission suggests that the role of profits in Indian economic growth be re-examined in the light of these facts and trends. The point of view taken by the authorities when the level of profits is a factor in fixing prices or tariffs is not reassuring. According to informetion made available to the mission, controlled prices and tariffs are set on the basis of a profit allowance that ranges from 8 per cent up to a maximum of about 12 per cent. Out of this profit the producers must pay interest on borrowed capital, bonus to employees, which is more or less compulsory, taxes and commissions to man- aging agents. Dividends are also normally a priority claimant on profits among Indian enterprises. Provision of funds for expansion or mocernization is seldom mentioned as a function of industrial profits. As a result, even - 23 - when profits were higher than they are now, relatively small amounts have been retained by companies for financing expansion. The mission believes that fresh consideration of the problem of industrial profits is especially important if private industry is to expand sufficiently to utilize the indus- trial materials and semi-manufactures which are going to come from the heavy industrial plants in the public sector. 38. According to Table 12, capital raised from the market (i.e. paid-up capital plus debentures) has on average provided somewhat more than 10 per cent of additional financial resources available to 1,001 companies during most recent years. New issues met with varying success, depending on the condition of the market and prospects for the company involved. During 1957, in connection with the slackening in certain sectors of industry, security prices fell. They have recovered since. Average yields to the investor in variable dividend industrial securities (based on tax-free rates) have de- clined correspondingly from almost 7 per cent during 1957/58 to a little over 5 per cent at the end o2 1959/60. 39. Borrowing by inaustrial enterprises from coniercial banks has been of increasing importance in recent years. This is also suggested by the fact that the share of advances to manufacturing industries in total advances of commercial banks has gone up from about one third at the beginning of the Second Plan to nearly one half at present. 4o. The category "Other Sources" in Table 12 includes, among other items, amounts borrowed from the IBRD an1 industrial finance corporations. Borrowing from the IBRD (by the iron and steel and electricity companies) was largest during 1957 and 1958 (for the two years together over Rs. 0.5 blLion). Although industrial finance corporations have been able to expand their acti- vities significantly in recent years, their overall importance for the financing of manufacturing industry in India is still modest. For instance, during 1956 and 1957 the net amount lent to 1,001 companies was only Rs. 0.06 bil'.ion, i.e. less than 1F per cent of the increase in total assets of these companies during these two years. 41. In order to enlarge medium-term credit facilities to the private sector, notably medium-sized industrial enterprises, a Refinance Corporation was established in June 1958. ./ The Cornoration is to provide re-lending facilities against lo,ns Liven by banks to industrial concerns for the purpose 1/ Of Qhe authorized capital of Rs. 250 million, shares of the face value of Rs. 125 million were allocated as follows: Reserve Bank of India Rs. 50 million, the Life Insurance Corporation, the State Bank of India and a group of fourteen other scheduled banks each Rs. 25 million. The initial paid-up capital is Rs. 25 million. The Government of India has agreed to make available to the Corporation an amount not exceeding Rs. 260 million ($55 million), representing U.S. PL 480 funds, as a 30-year interest- bearin: loan. - 24 - of increased production. 1/ So far the amounts lent by the Corporation have been very modest, and a change in its conditions of lending - now under con- sideration - appears essential if this situation is to change. 42. Information concerning sources of finance for investment in agri- culture and housing is too scanty and unreliable to allow a detailed analysis. Available indications are, houever, that capital formation in these sectors has been financed predominantly from their own resources, i.e. savings of individuals. Money Supply and Prices 43. Contrary to developments during the First Plan, when on the whole a large degree of both internal andexternal financial stability was main- tained, the financing of the Second Five-Year Plan has given rise to inflationary pressures. The main facts regarding the development of money supply and the factors underlying its variations are shown in the Statistical Appendix, Tables 14 and 15. 44. Total money supply has increased by about 23 per cent during the four years April 1956 - March 1960, against some 10 per cent during the First Plan period as a whole. By far the most important expansionary factor has been money creation by and on behalf of the Central and State Governments amounting to Rs. 11.25 billion during the first four years of the Second Plan (of the separate section about deficit financing). Deficit financing was preponderantly in the form of increased recourse to the Central Bank. Hold- ings of government securities of commercial banks (exclusive of the State Bank) rose on balance by almost Rs. 1 billion during April 1956 - March 1960. The holdings of government securities of the State Bank went up by more (those of medium and long-term government bonds alone by an amount of the order of Rs. 2 billion during the four years), but this increase was largely the result of the deposits made with this Bank by the Government of India in partial ful- filment of its obligations under the PL 480 agreements. The investments of the State Bank in government securities, insofar as they were the result of PL 480 deposits, were on balance not a money increasing factor, since the sale of PL 480 commodities inside India gave rise to a :ioney decreasing offset. 4.5- Credit extension to the private sector (plus some public enter- prises) has amounted to less than 40 per cent of that to Central and State Governments during the first four years of the Second Plan. Nevertheless, its amount was about double that during the whole period of the First Plan. 1/ Loans eligible for rediscount must be for periods between 3 and 7 years and of a medium-sized amount, not exceeding Rs. 5 million. The Corpora- tion charges $ per cent interest per annum on its loans to member banks. The rate charged by banks in turn is usually 61 per cent. - 25 - 46. The Reserve Bank has in general been following a policy of credit restraint during the Second Plan period, althourh at the same time trying to facilitate the extension of credits for necessary and productive purposes. Jhen appraising the effectiveness of credit controls in India, one should be aware o:f the inevitable limitations due to the large size of the so-called unorganized money market. For example, in spite o: the efforts to enlarge the share of credits to agriculture through normal bank channels in recent years, no more than some 12 per cent of total credits to agriculture outstanding today has been extended through the organized banking system. Currency accounts in India for about 70 per cent of total money supply, and this percentage is still practically The same as a decade ago. Also, the liquidity of the Indian banks has in general been hirh in recent ycars, their reserves exceeding the minima of 5 per cent and 2 per cent of demand and time liabilities respectively which they are required to maintain with the Reserve Bank. 47. Since 1956 the Reserve Bank has been empowered to increase the required reserves of commercial banks up to 20 per cent and 8 per cent in respect of demand and time liabilities respectively, but this provision has not been used so far, obviously on the ground that it would have worked too indiscriminately. Instead, the Reserve Bank has been availing itself recently of another provision enacted in 1956, viz. the power to require commercial banks to maintain with the Reserve Bank additional cash reserves, computed with reference to the excess of demand and time liabilities over the level of such liabilities on a base date. Thus banks were required to maintain with the Reserve Bank additional reserves equivalent to 25 per cent of the increase in deposits accruing after Iarch 11, 1960 (over and above the statu- tory minima of 5 per cent and 2 per cent), and the percentage of required additional reserves has subsequently been raised to 50 with respect to deposit accruals since May 6, 1960. The increased vigilance of the Bank has been prompted by the considerable rise in credits during 1959/60, together with the accelerated rise in prices. Other measures of credit control, applied by the Reserve Bank both recently and in earlier years, were selective credit con- trols, moral suasion and open market transactions. The bank rate was raised from 3-. per cent to 4 per cent in Iay 1957 and has been at that level since. 48. Against the increase in money supply caused by additional credit extension to the public and private sectors, there have been two major off- setting factors, viz. the rise in time deposits and the fall in foreign - exchan.e reserves. Time deposits (exclusive of PL 480 deposits) showed a centinuous and substantial rise, amuntin,j to somewhat less than Rs. 4 billion during the first four years of the current Plan. Foreign reserves dropped steeply during the first two and a half years of the Plan. Whereas the Plan foresaw a drawing down of sterling balances of no more than Rs. 2 billion during its whole period, the actual fall in foreign assets held by the Reserve Bank has been Rs. 5.49 billion during four years. Excluding net transactions with the International Monetary Fund, the figure was Rs. 6.27 billion. 49. Wholesale prices in March 1960 had risen 21 per cent compared to four years before and those for food alone 26 per cent. At the beginning of the Second Plan the Indian price level was relatively low. During the First Plan a fall had occurred on balance of about the same order of magnitude as - 26 - the rise which took place during the first four years of the Second Plan. The fall in prices during the First Plantasfirst of all a reaction to the very high price level which prevailed in the beginning of 1951 due to the Korean war, and it had been stimulated by the bumper crop of 1953/54, which caused a sharp drop in agricultural prices during 195h/55. On the other hand, mild inflationary pressures 'ecane noticeable in the Indian economy during 1955/56, and the general and food wholesale prices went up in that year by about 8 and 12 per cent respectively. 5o. The trend of food prices is of preponderant importance in the overall trend of wholesale prices (their weicht being over 50 per cent). The rise in food prices during the Second Plan has been ciscontinuous. In 1956/57 and 1958/59 it was 10 and 11 per cent respectively, but in 1957/58 food prices were stable on balance and during 1959/60 their rise was limited to 3 per cent. 51. Another noticeable feature of price movements during the last few years is that wholesale prices of industrial raw mat-rials and manufactures, which had risen by no more than 6 and 5 per cent respectively during the first three Plan years as a whole, went up by l and 8 per cent respectively during 1959/60 alone. 1/ The rise in prices of raw materials and manufactures is largely attributable to the changes in prices of raw cotton and jute, since textile fibres make up over one third of theveighting of the raw materials index and textiles account for over half thevaighting of the price index for manufactures. Nevertheless, the most recent rises in prices might be an indication that the imptct of deficit financing and severe import restrictions on the domestic price level has gained momentum. The all-India index of work- ing class consumer prices has risen by about 22 per cent during the period March 1956 - March 1960 against a fall of about 3 per cent during M-larch 1951 - March 1956. 52. Summarizing monetary and price developments during the first four years of the Second Plan it can be-said that the imp;:ct of the large amounts of deficit financing on domestic prices has been modest. In this context it should not be overlooked, however, that India has used practically all of its substantial excess foreign reserves in a period of less than three years. Since this cushion is no longer available, deficit financing will have to be cut considerably from now onwards if a more heavy pressure on domestic prices and costs is to be avoided. The increased rise in domestic prices of indus- trial raw materials and manufactures that has been noticeable during the last twelve months or so would seem to confirm the necessity of restraint in this respect. 1/ when monthly averages for 1958/59 and 1959/60 are compared, the rises in prices of industrial raw materials and manufactures are substantially lower, viz. 7 and 3 per cent respectively. - 27 - (B) SOURCES OF FINANCE FOR THE THIRD PLAN Public Sector General 53. The various sources of finance for public expenditures under the Third Plan are listed in Table 14. This table also makes possible a compari- son with the latest estimates for the Second Plan period which were discussed in previous sections. Sh. When comparing the amounts for the Third and Second Plan periods in Table 14, limitations of comparability should be kept in mind with respect to some items, Apart from those mentioned in the footnotes (which are not very important) it may be pointed out that: (a) the estimate for the amount to be raised from public loans during the Third Plan period is roughly Rs. 2.5 billion higher than the latest Planning Commission estimate for the Second Plan if one eliminates the special purchases of government bonds in connection with PL 480 local currency deposits (this local currency is now deposited directly with the Reserve Bank); and (b) the estimate of external resources of Rs. 22 billion includes the major share of the foreseen rupee proceeds of sales by the Indian Government of PL 480 commodities (about Rs. 6 billion gross minus an estimated Rs. 2 billion representing the value of commodities that will not be sold but added to buffer stocks), whereas, as mentioned earlier, the corresponding estimate of the Planning Commission for the Second Plan only includes PL 480 local currency released for spending on approved projects. 55. Expenditures in the public sector during the Third Plan remain heavily dependent on external aid, which is expected to contribute about 30 per cent of the finance required. Higher targets than in the Second Plan are set for additional taxation and surpluses of public enterprises, and consequently the amount of deficit financing assumed is very much less (about 10 per cent of total resources). 56. When appraising the various target figures, it should be realized that they are still tentative. In this respect the Plan Outline points out that the detailed discussions with State Governments on their resources are to take place during August and September 1960, that it will be necessary to review the estimates of the Center's resources towards the end of 1960 in the light of the latest trends, and that in respect of some of the resources, such as the surplus from public enterprises, further scrutiny will be required. 57. Nevertheless, on the basis of the more detailed analysis of individual sources of finance in later sections, some general impressions emerge. In the missionIs view some of the targets are within reach - notably those for the balance from current revenues, railways' contribution, additional taxation and small savings - although their attainment will by no means be - 28 - Table 14. Sources of Finance for the Second and Third Plans Rs. billion Per cent of Total Third Plan Second Plan Third Plan Second Plan Official Latest Estimates Official Latest Estimates estimates estimates based on estimates estimates based on based on mission based on mission Plann. defin. Plann. defin. Comm. Comm. defin. defin. Balance from current revenues at existing rates of taxation a/ 3.5 -1.0 -1.0 4.8 -2.2 -2.2 Railwayst contribu- tion on existing basis 1.5 1.5 J 1.5b 2.1 3.3 3.3 Surpluses of other public enterprises on existing basis . C/ c/ 6.1 . . . Additional taxation, incl. measures to increase surpluses of public enterprises 16.5 10.0 10.0 22.8 21.7 21.7 Public loans (net) 6.5W/ 8.0 3.0 9.0 17.4 6.5 Small savings 5.5 3.8 3.8 7.6 8.3 8.3 Unfunded debt and miscellaneous capital receipts e/ 5.1 2.1 2.3 7.0 5.5 5.1 External resources 22.0 9.8 13.1 30.3 21.3 28.5 Deficit financing 7.5W 11.8 13.3 10.3 25.7 28.8 Total expenditure under Plan 72.5 46.0 46.0 100 100 100 a! Rates of taxation existing during 1960/61 (for Third Plan) and 1955/56 (for Second Plan); balance arrived at before taking into account additional taxa- tion and current expenditures on development insofar as included in the Plan. b Inclusive of increases in fares and freights. j Included in balance from current revenues. d The official target for public loans during the Third Plan is Rs. 8.5 billion. This figure has been decreased by the mission by a notional sum of Rs. 2 bil- lion, in order to take account of the amount of additional bonds that will have to be absorbed by the banking system. Correspondingly the mission has raised the official figure for deficit financing during the Third Plan (Rs. 5.5 billion) by Rs. 2 billion. e/ Includes substantial estimated revenue on account of betterment levies and Steel Equalization Fund for Third Plan period. - 29 - easy. The attainment of the amount estimated for the balance from current revenues hinges to a considerable extent on the acceptability of the assumed rate of income growth of over 5 per cent per annum. The target figure for additional taxation requires a substantial additional effort in the States as well as at the Center. The target for small savings is quite high against the background of realization figures. 58. With respect to the item "Unfunded Debt and Miscellaneous Capital Receipts", the mission expects shortfalls because it has doubts about the possibility of raising the proceeds from the steel equalization levy and betterment levies to amounts as high as those mentioned in the Plan Outline. 59. The target figure for surpluses of other public enterprises on the ex- isting basis is very hard to appraise since it depends on many factors which are still largely unforeseeable. On account of public plants owned and to be owned by the Central Government the mission expects a shortfall in the estimated surplus of at least Rs. 1 billion. On the other hand, it feels that the estimated surplus from State electricity undertakings might be susbstantially exceeded if realistic rate policies were to be followed; this might then largely compensate for a shortfall with respect to other enterprises. 60. The mission considers the official figure of Rs. 5.5 billion for deficit financing to be quite moderate, but it is of the opinion that the Plan Outline as it stands implies a larger amount of mone.- creation, since the target figure for public loans can be considered realistic only if one assumes that an amount of Rs. 2 billion or so of additional bonds will be absorbed by the banking system. Allowing for this, the figure for deficit financing goes up to Rs. 7.5 billion. This last figure is still not very high, but nonetheless a cautious approach to deficit financing will be necessary. 61. In brief, the mission foresees some shortfall for total domestic resources other than deficit financing as a whole compared to the combined target. Nevertheless, so long as resolute action is taken at the political level to mobilize additional savings, we do not believe that the shortfall will be so serious as to constitute a major limitation on the execution o'f the Third Five-Year Plan. The most crucial problem will be that of obtaining the large external resources without which the realization of a plan of the size envisaged would not be possible and without which there would be little hope of achieving anything like the rate of income growth assumed. 62. Meanwhile the task of mobilizing adequate domestic resources will not be an easy one. This is not only so with respect to the raising of resources proper, as indicated earlier, but also with respect to the neces- sity for keeping down the level of non-Plan expenditure. 63. The financing of Plan expenditures by the States will depend heavily on financial assistance from the Center. Of the total of Rs. 72.5 billion to be spent in the public sector, about Rs. 36.5 billion (one half) will be spent by the States. Against this, the amount of Central assistance - 30 - to the States is expected to be of the order of Rs. 25 billion. (Over the first two Plans, State plans will together account for a total outlay of Rs. 38 billion, of which over Rs. 22 billion is expected to be financed by the Center.) Balance from Current Revenues 64. According to the latest estimates of the Planning Commission, current budgetary revenue is expected to exceed current budgetary expendi- ture outside the Plan by about Rs. 3.5 billion during the Third Plan period. This balance, which is Rs. 4.5 billion more favorable than the corresponding amount during the period of the Second Plan, is exclusive of the anticipated proceeds from additional taxation and surpluses of public enterprises (to be discussed later), but includes as a deduction item certain capital expendi- tures outside the Plan, notably on defense. 65. The balance in question is very difficult to appraise, both because of the considerable number of revenue and expenditure items involved and their large total amounts. At the time of its visit to the country the mission was provided with a copy of an extensive study on the subject; this study arrived at a favorable balance of Rs. 2 billion, the underlying totals of revenue and expenditure being Rs. 82.7 and Rs. 80.7 billion respectively. It is obvious that relatively small percentage changes in the totals of revenues and expenditure can affect the balance substantially. The estimate of Rs. 3.5 billion given in the Plan Outline takes account of a recent upward revision of the balance, mainly on the ground that the revised budget estimates for 1959/60 and the original budget estimates for 1960/61 foresee a higher level of revenue towards the end of the Second Plan than was anticipated earlier. 66. The mission considers the balance of Rs. 3.5 billion for the moment as an acceptable target figure. As remarked already, it is the product of extensive study. On the revenue side it allows for considerable increases under major items, but these are consistent with the most fundamental assump- tion on which the estimates for revenue are based, namely that national income will rise by over 5 per cent per annum; this assumption is in line with the general Plan target for income growth. On the side of expenditure the target figure allows for reasonable increases of major items like expenditure on wages and salaries (for which raises are due at both the Center and the States in view of the recommendations of the Pay Commission), defense outlay, interest payments and so-called committed development expenditure. The latter represents essentially outlays necessary to maintain the development effort undertaken prior to the start of the Third Plan at its existing level. 67. In spite of these considerations, the realization of a surplus of Rs. 3.5 billion can by no means be taken for granted. The assumed rise in national income underlying the revenue estimates is high, particularly against the background of past performance. In case of a smaller increase in national income the envisaged rise of current revenue would presumably - 31 - be affected more than that of current non-Plan expenditure. Also, experience with respect to the trend of current non-Plan expenditure auring the past few years has shown that moderation in spending will require a continuous and close supervision of major expenditure items, both at the Center and in the States. This is not an easy task in a country like India where spending is so strongly decentralized. Contribution of Public Enterprises 68. Railways. The following discussion of the financial position of the Railways disregards the envisaged increases in rates during the Third Plan, which are considered later (see paragraph 78). 69. The latest estimate made by the railways of their overall resources position during the period of the Third Plan foresees a gross surplus of Rs. 8.35 billion. This figure takes account of the recent raise in railway rates of about Rs. 0.14 billion annually in order to cover salary increases as recommended by the Pay Commission and some other rises in costs. From it has to be deducted an estimated Rs. 3.55 billion as dividends to the Indian Government, which is a contribution of the railways to the financing of Plan expenditures in a wider sense. The remaining amount of Rs. 4.80 billion corresponds to a net contribution of the railways towards the financing of the Third Plan as envisaged by the Planning Commission of about Rs. 1.50 billion if one assumes a yearly amount to be set aside for depreciation of Rs. 0.66 billion (Rs. 3.30 billion for five years). 70. As things stand the amount for depreciation may be increased to Rs. 0.70 billion annually. During the Second Plan the railways drew on their depreciation funds (held with the Center) to an amount of Rs. 3.20 billion (against accruals of Rs. 2.25 billion), and they are now considering the desirability of a replenishment of these funds. If this were to happen, the contribution of Rs. 1.50 billion as calculated (which the mission finds no reason to quarrel with) would go down to Rs. 1.30 billion. 71. This reduction would not mean, of course, a fall in resources available for the financing of the expansion of the railways. But it under- lines the limited importance of the use of a net concept (as done in the Plan) instead of a gross concept in the context of an analysis of available financial resources. The same limitation is evident in relation to the Second Plan (see footnote to paragraph 17 above). 72. Other Public Enterprises. Public enterprises other than the railways are expected to make a substantial contribution to the financing of expendi- tures in the public sector during the Third Plan. The latest estimate for the combined surpluses of these enterprises for the five-year period amounts to Rs, 4h. billion, of which Rs. 3 billion is supposed to be contributed by enterprises of the Central Government and Rs. 1.4 billion by enterprises owned by State Governments. - 32 - 73. The Plan Outline provides very little detail about these estimates. It is pointed out that they represent the balance of resources available with public enterprises after providing for their working expenses as well as depreciation outlays (as distinct from the amounts of profits set aside for depreciation purposes). It is also remarked that "the estimates have been made on certain broad assumptions and are, therefore, very rough. It is proposed to examine them in greater detail... before the Plan is finalized." 74. On the basis of more detailed information provided to the mission during its stay, it is understood that the major contribution of enterprises owned by the Central Government is expected to come from the public steel plants and fertilizer factories, with smaller amounts to be contributed by a considerable number of other enterprises, both existing ones and enterprises to be started during the Third Plan. The major surpluses of State Government enterprises are supposed to be accumulated by the State electricity under- takings, with State transport undertakings accounting for the remaining portion. 75. The mission recognizes that some allowance has to be made for this source of finance, but the inclusion in the forecasts of an item of more than Rs. 4 billion that is heavily dependent on the operating efficiency, pricing and general earning capacities of the new public enterprises raises many questions. It must be regarded as one of the least reliable figures in the whole financial forecast. Unfortunately, it is large enough to be troublesome if it should turn out to be a substantial overestimate. 76. The new public enterprises will all have a substantial breaking-in period during which it would be unrealistic and probably unwise to insist that they return a financial surplus to the Central or State treasuries. In many cases, only an accounting policy that ignored important real capital costs could possibly yield such surpluses. Pressure on the enterprises to produce quick surpluses could lead to pricing policies that ignored long-run growth considerations. The whole question of the proper relation- ship between the prices of different services or products produced by publicly owned enterprises, particularly those in economically related sectors of the economy, such as the price of steel and the railway rates for coal or iron ore, needs more consideration than it has yet been given in India. 77. We feel that for a number of public sector plants, including steel and fertilizer factories and oil refineries, there are many reasons to expect costs to be higher and financial results less favorable than assumed and few reasons to expect variations from the estimates in the opposite direction. On account of this we would reckon with a shortfall of at least Rs. 1 billion in this item over the period of the Third Plan. On the other hand, we also are of the opinion that the estimated surplus from State electricity undertakings (underlying the amount of Rs. 1.4 billion to be raised from all State enterprises) might be substantially exceeded if realistic rate policies were to be followed; this might then largely com- pensate for a shortfall with respect to other plants, - 33 - Additional Taxation 78. The target figure for additional taxation, including measures to increase the surpluses of public enterprises, is Rs. 16.5 billion. The Plan Outline naturally does not say exactly how this result is to be achieved, pointing out that "the details of tax measures to be adopted will have to be decided upon in the light of the emerging economic situation". Present thinking, as outlined to the mission, is towards reliance on increases in Central excise duties to provide about one third of the total and on increases in income tax aidcorporation tax to provide about one fifth. Increases in land revenue, surcharges on commercial crops and water rates are regarded as other important sources of additional revenue. So also are State sales taxes and special taxes on transportation and electricity. It is assumed that at least one third of all the revenue from additional taxation will have to be raised in the States. 79. The Plan Outline points out also that, whereas tax revenue in India now totals about 8.5 per cent of national income, the additional taxation proposed for the Third Plan should raise the proportion to dout 11 per cent. "This cannot be considered an excessive increase in the tax burden... Never- theless, an additional target of Rs. 16.5 billion will involve considerable effort on the part of the Central and State Governments to broaden their tax structure...1 The mission concurs in both these judgements. 80. Indeed, in our view, the additional taxation proposed should be regarded as a minimum target. We believe not only that it can be achieved, but might be exceeded, without imposing intolerable hardships on the poorest. The view sometimes expressed that the States will find it politically difficult or impossible to meet considerably larger revenue targets for the Third Plan period was not shared by responsible ministers in several of the larger States visited by the mission. 81. In spite of recent increases in taxation the incidence of direct taxes in India has remained uneven. The rural community as a whole is much more lightly taxed than the urban. The effective tax burden is also unequal because considerable tax evasion persists and the possibilities of evasion apparently are much larger for some groups of the economic community,such as merchants and landowners, than for others like wage-earners or the larger corporations. Also, recent studies have shown that, whereas high incomes are taxed heavily, the tax burden on middle income groups is relatively light as compared to other countries. The Government is aware of the necessity to increase revenue from land, in spite of the expectation of strong political opposition. It also has under serious consideration the higher taxation of middle income groups, including the better paid wage-earners. 82. In the mission's opinion a further increase in direct taxation should not be pursued by a further stepping-up of the tax rates applicable to enter- prises and the upper income groups, which are already quite high. In view of the downward trend of recent years in the relationship between profits - 34t - withheld by companies and amounts spent on additional investment there rather appears to be scope for a strengthening of incentives to increase self-financing of expansion in the private sector of the economy. 83. Indirect taxes now account for roughly 70 per cent of total tax revenue in India, and for many years to come revenue from these taxes is bound to remain larger than that from direct taxes. It is only natural, therefore, that attention should be particularly focussed on this source. If, with the envisaged increase in national income, the rise in consumption is to remain limited, indirect taxes on a range of commodities will have to be stepped up. A considerable part of the higher incomes during the Third Plan will accrue to urban centers and will probably be spent on semi-luxuries such as bicycles, tobacco, fans, shoes, etc. Commodities like these should be a key target for increased indirect taxation. More indirect taxes might also be raised from petroleum products, especially those for which demand outstrips the capacity of Indian refineries, such as kerosene and diesel oil. With increased industrialization and a gradual advance in living standards consumption of petroleum products is bound to grow rapidly, and they can provide, as the experience of many other countries shows, a source of sub- stantial additional revenue. As a step in this direction the budget for 1960/61 already provides for an increase in the excise duty on refined diesel oil. 84. Apart from comments on the evasion of taxes, the mission heard during its visit complaints about the intricacy of the present tax system and about uncertainty in particular cases as to what tax liabilities are. Although these complaints may well be exaggerated, as any modern tax system is bound to be complicated in its details, the mission feels that they should not be ignored, as undue and unnecessary complexity can become a serious source of weakness in a tax system. A valuable contribution was made by the recent simplification in taxation of dividends and related changes in taxation of corporations (see Appendix II to this annex). Public Loans 85. The target figure for the Third Plan for public loans is Rs. 8.5 billion, against a realization figure for the period of the present Plan now estimated at Rs. 8 billion. These figures are not comparable, however, due to the special investments in recent years by the State Bank in government bonds on account of PL 480 local currency deposits. These deposits are now made directly with the Reserve Bank, and consequently the special purchases of government bonds do not take place any longer. If one eliminates this factor, the Third Plan figure implies an increase over that for the Second Plan of more than Rs. 2.5 billion. The gross figure for public loans is about double the net figure of Rs. 8.5 billion in view of forthcoming amortization commitments. 86. Leaving aside the banking system, the Life Insurance Corporation (L.I.C.) and the Statutory Provident Funds are among the most important in- vestors in government bonds. A recent survey carried out by the Reserve Bank showed that in the calendar year 1958, out of a total of about Rs. 0.75 billion government bonds absorbed by others than the banking system and Governments themselves, Rs. 0.29 billion was absorbed by the L.I.C., Rs. 0.24 billion by Statutory Provident Funds and Rs. 0.19 billion by various investors (including individuals, trusts, local authorities, joint stock companies and finance corporations). - 35 - 87. The L.I.C. expects to be able to expand its insurance portfolio con- siderably during the years to come. It has set itself a target for new capital insured of . s. 10 billion during 1963 against a total of new insurance of some- what more than s. 4 billion during 1959. The increase in the sums to be in- vested equals roughly 10 per cent of these amounts, and future investments in governaent securities may be reasonably anticipated at a minimum of 55 per cent of the increase in assets. The law requires a minimum of 55 per cent of the assets of the L.I.C. to be in the form of Central and State Government securities and other approved securities; the percentage actually invested in these securities is somewhat higher at present. There would thus be at least a doubling of the yearly investment in government securities by the L.I.C. to Rs. 0.55 billion in 1963 as a minimum. Even if the target should turn out to be too optinistic, it seems likely that total new insurance contracted by the L.I.C. will grow sizeably during the Third Plan. 88. Statutory Provident Funds include the Employees' Provident Fund, the Coal nines Provident Fund and other Provident Funds. The Employees' Provident Fund included by the end of 1958/59 establishments that employed 50 or more persons in 39 industries. Other Provident Funds include a number of large factories and other establishments to which the Employees' Provident Funds Act is aoplicable; these establishments have been permitted to run their own scheme of Provident Fund on certain conditions, the most important of which is that investments shall exclusively be made in Central Government securi- ties. The Coal Mines Fund is much less important in quantitative terms. The absorption of government bonds of these various funds combined will grow during the Third Plan - even without the possible expansion of the coverage of the schemes - due to the increase in the number of subscribers and their wages and on account of larger earnings on fund assets. 89. In view of the factors just mentioned it is realistic to expect an increased absorption of government bonds by the non-banking, non-government sector which under favorable circumstances might well go u to something like Rs. 2.5 billion. Even so, it will only be possible to realize a target figure for new loans of Rs. 8.5 billion without recourse to the Heserve Bank if one assumes at the same time substantial proceeds from bonds to be absorbed by the commercial banks and from the envisaged issue of prize bonds. 90. 14ith respect to the potential market for prize bonds the mission heard conflicting views expressed during its visit. On the one hand, the initial success of the issue of prize bonds since April 1960 (under the small savings scheme) was mentioned as an indication of an important potential market for this sort of investment. But the mission also heard the view ex- pressed that the initial demand for prize bonds did not necessarily mean that it would be lasting, nor that it would not represent a shift from one type of investment to another. 91. The absorptive capacity of the commercial banks for government bonds is determined in particular by the increase in deposits (itself again largely dependent on the amount of deficit financing in the public sector) and by the additional demand for credit of the private sector. As indicated elsewhere, - 36 - the mission prefers to include the increase in the portfolio of government bonds of the commercial banks as an element of deficit financing, since it gives rise to an increase in money supply. 92. Summarizing, the mission feels that the target of Ps. 8.5 billion is high and in part based on optimistic assumptions; in particular, the un- certainties surrounding the issue of prize bonds are evident. ioreover, the mission advocates for monetary reasons the exclusion from the item public loans of the additional amounts of government bonds to be absorbed by the banking system. If this is done, there is no doubt that the target figure is too high by Terhaps Rs. 2 billion. Any shortfall will have to be compensated by additional recourse to deficit financing. Small Savings 93. The estimate for small savings during the Third Plan is Rs. 5.5 bil- lion, whicn is Rs. 1.7 billion or almost 45 per cent in excess of the latest estimate for collections during the Second Plan. The target figure for the Third Plan is high, as is pointed out in the Plan Outline itself. No doubt there is a ootential for a further rise in small savings, demonstrated e.g. by the fact that collections so far have been relatively much larger in some States than in others. Also, the various measures taken to increase the attractiveness of small savings, the strengthening of the underlying organiza- tion and the anticipated rise in national income make higher estimates justi- fiable. Nevertheless the target figure should be considered as a maximum estimate. Unfunded Debt and iiscellaneous Capital R.eceipts 94. The Plan Outline foresees total revenues to the amount of Rs. 5.10 billion from this source and orovides the following breakdown: Provident Funds (net additions) Rs. 2.30 billion Betterment levies Rs. 0.75 " Steel tqualization Fund Rs. 1.60 " Balance of miscellaneous capital receipts over expenditures Rs. o.45 " Total Rs. 5.10 billion 95. The estimate for Provident Funds appears realistic if one assumes a gradual increase of net yields from Rs. 0.42 billion in 1961/62 to Rs. 0.50 billion in 1965/66. These prospective yields are in line with recent realiza- tion figures. (The principle of compulsion with respect to contributions applies to Central Government employees, but not to those of State Govern- ments.) 96. Revenue from betterment levies has been almost negligible so far (less than Rs. 0.05 billion during the total period of the Second Plan). The Plan Outline provides the following detailed information about this - 37 - source: "Legislation for betterment levy has already been passed in most of' the States. Recoveries at the prescribed rate are spread over a period of 15 to 20 years and commence 2 or 3 years after irrigation waters become available. The enforcement of the legislation has lagged behind, and the actual realiza- tions have been much below the targets initially proposed for the Second Plan. The need to promote the necessary legislation in the remaining States, and to enforce the legislation where it has already been passed, are essential steps to be taken during the last year of the Second Plan". Although it is reason- able to expect a certain measure of success in collecting larger amounts from betterment levies during the Third Plan period, the mission would be surprised if total revenue should rise as high as Rs. 0.75 billion. It considers a more or less substantial shortfall likely. 97. The estimate of is. 1.60 billion for the amount to be raised for the Steel Equalization Fund by means of surcharge on steel is considered by the mission as too high. As argued elsewhere in the report, the mission believes the targets for steel Droduction during the Third Plan to be out of reach. 98. The item miscellaneous capital receipts (net) is difficult to ap- praise since it is the balance of a considerable number of debit and credit items with nartly erratic trends. Among the major items which are included on the receipts side are recoveries of loans and advances from local bodies, cultivators and others and inflows under the heads of deposits and remittances. On the expenditure side there are included, among others, State trading in foodgrains, compensation payments to displaced persons and landlords, loans and advances to cultivator s.and others for non-Plan purposes and loans to foreign Governments. The mission considers the inclusion of the relatively modest amount of Rs. 0.45 billion on account of this source among Plan re- sources as justified, particularly in view of the large amounts of loans out- standing that were granted during the First and Second Plans (largely as ex- penditure under the Plan) to third oarties. It should be possible to recover substantial sums from this source. External Resources 99. The Plan Outline contains an item "budgetary receipts corresponding to external assistance" to the amount of Rs. 22 billion among resources avail- able for public expenditures under the Third Plan. As discussed elsewhere in this report, estimated total external assistance required for the Plan is Rs. 32 billion. The amount of Rs. 22 billion can be broadly reconciled with the last-mentioned figures as follows: - 38 - Rs. billion Total external assistance required for the Plan 32 of which: Repayments of external obligations 5 Assistance directly to private sector 3 PL 480 commodities for buffer stocks 2 Total deductions 10 Budgetary receipts corresponding to external assistance 22 The item "Assistance directly to private sector" relates to private capital inflows, as well as to direct loans from agencies like the World Bank, the International Finance Corporation and the U.S. Export-Import Bank. As explained in the Plan Outline, the deduction of Rs. 2 billion is based on the consideration that commodities to be delivered under the latest PL 480 agreement with the United States, insofar as they will be used for the accumulation of stocks, will not yield rupee resources. 100. With respect to the inclusion among "budgetary receipts corresponding to external assistance" of amounts on account of PL 480 deliveries the Plan Outline also points out that "part of the supplies under the PL 480 agreement signed recently is expected to be received during the current year, but we may take this entire import as related to the Third Plan period." (The recent PL 480 agreement involves a total amount of about Rs. 6.08 billion.) The mission has no reason to dispute this procedure; it seems reasonable to assume that more assistance under PL 480 will be forthcoming as long as India is not self-sufficient in foodgrains. However, two additional aspects should be kept in mind. 101. In the first place the Government of India will on balance not be provided with budgetary resources insofar as amounts of PL 480 local currency will have to be made available for spending by the U.S. authorities. In the second place - and more important - it should not be overlooked that all releases from the U.S. Title Account, which are bound to grow substantially during the Third Plan, have monetary implications. Releases for use by the U.S. authorities are an addi- tional money-creating factor. Releases for spending on approved Plan projects on the other hand do not increase the money supply by more than is foreseen on account of deficit financing in the Plan, unless these projects would be additions to the Plan. - 39 - Deficit Financing 102. Rs. 5.5 billion of expenditures in the public sector of the Third Plan are intended to be financed by means of deficit financing (this term being used here in the meaning attached to it by the Planning Commission, i.e. mobilization of resources essentially through the issue of Treasury Bills and possibly by the use of cash balances). The Plan Outline gives the following justification of this figure: "On a broad consideration of the trends in aggregate output, one might assume that money supply could increase by about 33 per cent in the Third Plan period without causing excessive pressure on prices. On the basis of an estimated quantum of money by the end of the Second Plan, the additional money supply permissible in the Third Plan period would be of the order of Rs. 9.5 billion - if it is assumed that money supply and aggregate output would be approximately in balance at the end of the Second Plan. Part of t4e increase in money supply comes about through the banking system-/. Allowing for this, the amount of budgetary deficits that could be considered permissible for the Third Plan period is taken at Rs. 5.5 billion. It must be emphasized, however, that decisions regarding deficit financing have to be taken in the light of the economic situation as it emerges from time to time. A great deal depends on how far production increases, especially in agriculture, and how effectively inflationary trends are held in check." 103. In the mission's view an amount of deficit finance of Rs. 5.5 billion as proposed by the Planning Commission (which would by and large imply an increase in money supply to the same amount) is by itself a reasonable target figure, considering the fact that in a country like India the monetized part of national income is bound to grow more rapidly than national income as a whole. Compared to the Second Plan the proposed amount of deficit financing during the Third Plan would mean a substantial reduction. This reduction is necessary since there will be no longer a cushion of foreign reserves to absorb inflationary pressures, and it is desirable that prices during the Third Plan should remain as stable as possible. 104. However, the Plan Outline as it stands implies a larger amount of money creation than Rs. 5.5 billion since the target figure for public loans (of Rs. 8.5 billion) can be considered realistic only on the assumption that a substantial part of the additional government bonds (say to an amount in the order of Rs. 2 billion) will be absorbed by the banking system. 1/ The estimate of Rs. 5.5 billion for deficit financing in the public sector allows for an increase in banking credits to the private sector within the context of the total "permissible" increase in money supply of Rs. 9.5 billion (footnote added by mission). - 40 - 105. Also, the mission is inclined to stress more than the Plan Outline does that an estimated margin for deficit financing should not be considered "1permissible" beforehand. For this there are several reasons: (a) it may well be that the Third Plan will start in a somewhat inflationary environment (due to the large-scale deficit financing pursued during the Second Plan); (b) the rise of 5 per cent or so per annum in national income, which is one of the basic assumptions for the calculation of the available margin for deficit financing, cannot be taken for granted for the Plan period as a whole, let alone for individual years; and (c) experience has shown that flexibility in Plan spending is limited in the short run. 106. Much emphasis is now placed in India on the desirability of stable prices of a number of key commodities, and a special committee is looking into this matter. Price stability in a few key sectors will no doubt contribute considerably to the success of the Third Plan. But it cannot be a substitute for the necessity to preserve over-all monetary stability. If the money supply were to be increased too strongly, harmful effects like price rises of other than key commodities, over-valuation of the currency, increased necessity for controls to safeguard the balance of payments position, a setback in private savings and a distortion of the investment pattern in the private sector would be most'likely to occur. 107. In conclusion, the mission feels that although the official estimate for deficit financing is not high, a cautious approach to the problem will be necessary for the various reasons mentioned. Private Sector 108. Total net investment in the private sector is estimated at Rs. 42 billion/- during the period of the Third Plan, against Rs. 33 billion during the Second Plan period. Of the investment total of Rs. h2 billion the sector of large-,and medium-scale industry and minerals accounts for Rs. 10.5 billion, agriculture for Rs. 8.5 billion, housing and other construction for Rs. 11.25 billion and power, transport and village and small industries for Rs. 5.75 billion. Within the total of Rs. 42 billion provision has also been made for investment in inventories to the extent of Rs. 6 billion. 109. The Plan Outline gives only scanty indications about the financing of private investment, which is understandable in view of the scarcity of data. The basic argument is that, since in most sectors the envisaged increases in investment are relatively modest, some stepping up of the 1/ This amount includes a sum of Rs. 2 billion corresponding to transfers from the public sector for capital formation in the private sector. The Rs. 2 billion are a part of the target figure for spending in the public sector of the Third Plan, which is Rs. 72.5 billion. - 41 - traditional sources of finance will be adequate. More detail is provided only for the sector large- and medium-scale industry and minerals where investment is anticipated to rise by 50 per cent compared to the latest estimate of Rs. 7 billion for the Second Plan period. (Investment by way of modernization and replacement in this sector is expected to be Rs. 2 billion during the Third Plan. It is not included in the figures just quoted.) It is estimated in the Plan Outline that of the total private investment in the sector of large-and medium-scale industry and minerals, inclusive of expenditures on modernization and replacement, almost half will be financed from internal resources (net of repayment liabilities), almost one quarter from direct external assistance and most of the remaining quarter or so from new capital issues, loans from various finance corporations, banking credits, etc. It should be remembered that the estimated contribution of internal resources to the financing of industrial investments refers to an investment total without stocks. When related to industrial investments inclusive of stocks, the share financed from internal reserves will presumably be of the order of no more than 40 per cent, a percentage similar to that for the Second Plan. 110. In the other sectors, notably agriculture and housing, private investment has traditionally been financed largely by internal savings of individuals. This situation is expected to continue in future. - 42 - APPENDIX I TO ANNEX VII Impact of PL 480 Surplus Goods Deliveries on Domestic Finance in India PL 480 has, as far as its impact on domestic finance in India is concerned, three different angles: (1) it affects the monetary situation; (2) it affects the budgetary situation; and (3) it affects the financial resources for the Plan. (1) Impact on Monetary Situation Three aspects can be distinguished: (A) the transfer of rupees by the Government of India to the Government of the US (to the so-called US Title Account, held with the State Bank of India); (B) the sale of PL 480 surplus goods by the Government of India inside India; (C) releases from the US Title Account for various purposes. (A) Transfer of Rupees to US Government On receipt of shipping documents, the Government of India pays for the imports by crediting to the US Title Account with the State Bank of India the full value of imports plus 50 per cent of freight charges. In order to have the money to make these payments, the Government of India sells Treasury Bills to the Reserve Bank. The US deposits with the State Bank are mainly in the form of time deposits, and the State Bank invests these funds largely in government securi- ties. The government securities are obtained by the State Bank largely from the Reserve Bank (which subscribed to public loans earlier); in other words, there is a shift of certain amounts of government securities (essen- tially long-term government bonds) from the Reserve Bank to the State Bank. It is obvious that these various transactions combined as such do not give rise to an increase or decrease of the total money supply in India. Assuming that 100 units are transferred to the US Title Account, the results will be: Reserve Bank (assets): Treasury Bills plus 100; long-term government bonds minus 100; State Bank (assets): Long-term government bonds plus 100; State Bank (liabilities): US Title Account (time deposits) plus 100. - 43 - It follows from this analysis that in calculating the amount of "deficit financing" (in the sense of money creation by or on behalf of the Government) it is desirable to net out the sale of Treasury Bills to the Reserve Bank (otherwise an amount of deficit financing of 100 would be regis- tered statistically, for the increase in holdings of government securities by the banking system of 100 - due to the selling of Treasury Bills to the Reserve Bank - is considered to be a money-increasing factor). Statistically this netting out is accomplished by the inclusion of the increase in the US Title Account with the State Bank as a money-decreasing factor in the calcula- tion. In fact this amounts to treating the rupee balances in the US Title Account as equivalent to government balances in the context of the analysis of the causes of variations in money supply. Following are some details relating to the transfers made to US Government account: (a) The gross accruals to the US Title Account on account of PL 480 shipments have been as follows (in Rs. billions): Total 1956/57 1957/58 1958/59 1959/60 4 years 0.44 0.97 0.87 1.02 3.30 (b) The amounts that have accrued on balance to the US Title Account with the State Bank in the various fiscal years have differed somewhat from the figures just given for the following reasons: - There were small accruals on account of PL 665 deliveries (Rs. 0.32 billion in total of which Rs. 0.15 billion during the Second Plan; no further accruals will take place on account of this). - There have been releases from the Title Account (see below aub. C). - Small amounts have been transferred by the US authorities from the account with the State Bank to other bank accounts in India. (c) The State Bank has not invested the full increase in its deposits due to PL 480 in government securities. This is confirmed by the following changes in its assets (in Rs. billions; last Friday figures): Oct. March Net 1956 1960 Change Investment in government securities 0.93 3.43 +2.49 Cash on hand and balances with the Reserve Bank 0.13 0.41 +0.28 (Only a relatively small amount was deposited in the US Title Account prior to October 1956) - 144 - (d) Part of the increase in government securities held by the State Bank has been in the form of Treasury Bills. (e) The State Bank may have obtained part of its additional government securities from subscriptions to new loans or by purchases from others than the Reserve Bank. (This does not affect the conclusion that the net increase in the US Title Account should be treated as a money-decreasing factor.) (f) Payments by the Government of India to the US Government will hence- forth be made to an account held in the Reserve Bank. (This change became effective on May 16, 1960.) (B) Sale of Surplus Commodities in India The sale of surplus goods by the Government of India inside India gives rise to a withdrawal of money from circulation (money-decreasing factor.) In practice, it is impossible to trace the amounts involved sepa- rately, since the Government sells PL 480 wheat, wheat obtained from normal imports, and wheat procured domestically, and these various sources are not administered separately. Also, some of the wheat sold is subsidized (the amount of the subsidy varying with domestic price conditions). By and large it can be said that, leaving aside possible time-lags and changes in stocks, the money-decreasing factor has been almost equal to the amounts transferred prior to the sales to the US Title Account. (C) Releases of Funds from US Government Account Releases from the US Title Account take place in accordance with the provisions made in the PL 480 sales agreements. The broad picture of uses for the four agreements signed until the end of 1959 (including addi- tional agreements) is as follows: (1) For loans to the Government of India Rs. 2.43 billion (2) For grants to the Government of India Rs. 1.00 billion (3) Rupee loans through Eximbank (Cooley amendment) Rs. 0.45 billion (4) For US uses Rs. 0.74 billion Total Rs. 4.62 billion The latest PL 480 sales agreement (signed May 4, 1960), involving an amount of $1,276 million (i.e. about Rs. 6.08 billion equivalent), pro- vides for releases as follows: (1) For loans to the Government of India Rs. 2.56 billion (2) For grants to the Government of India Rs. 2.56 billion (3) & (4) For US uses (including Cooley amend- ment) Rs. 0.95 billion Total Rs. 6.08 billion Actual releases for the first two purposes have only been small so far. They were as follows: Year As loan As grant PurDose for which received 1958/59 Rs. 0.05 billion - For being re-lent to Refinance Corporation 1959/60 Rs. 0.23 billion Rs. 2.8 million For irrigation and power projects Rs. 0.28 billion Rs. 2.8 million With respect to (3) no cash payments inside India have been made as yet (almost Rs. 0.09 billion has been obligated for this purpose). On account of (4) almost Rs. 0.15 billion had been spent or obli- gated (of which perhaps some Rs. 0.10 billion spent) by the US authorities at the end of February 1960. Summarizing, it can be said that the impact on the monetary situ- ation consists of the contractionary effect on money supply of sales of PL 480 commodities by the Government inside India versus the expansionary effect of the spending of amounts released from the US Title Account. So far the latter has been very small compared to the former. (2) Impact on Budgetary Situation PL 480 transactions give rise to a number of entries in the budget of the Government of India. These entries can be summarized as follows (the figures have been added for purposes of illustration): Receipts Disbursements (A) Payment to US Sales of Treasury Capital outlay on schemes Title Account Bills to Reserve of Government trading Bank 10C(C) l00(C)* (B) Sale of PL 480 Capital receipt on Redemption of Treasury goods by Govern- schemes of Govern- Bills placed with Reserve ment ment trading 95(C)* Bank 95(C) (C) Receipt of loan from USA (I) Public debt 20(C)* (II) Special Development Transfer of sale pro- Fund - Assistance ceeds of American loan under PL 480 20(P) commodities 20(C)* Receipts Disbursements (D) Receipt of grant from USA (I) Extraordinary receipts 10(C)* (TI) Special Development Extraordinary charges Fund - Assistance 10(C)* under PL 480 10(P) (E) Expenditure on approved schemes (I) Appropriate head of expenditure 30(C) (II) Appropriate head of Special Development Fund expenditure to which - Assistance under PL expenditure was 480 30(P) debited 30(C) (C) = Consolidated Fund of India (P) = Public Account of India * = Items included by Planning Commission under miscellaneous capital transactions (see below) As will be seen, it has been assumed - in accordance with practice - that the sale proceeds are somewhat smaller than the amount paid to the Title Account due to subsidizing of sales. The preceding outline disregards the possible effect on the budgetary position of sales of government securities to the State Bank. (3) Contribution to Resources for the Plan The following items of resources for the Second Plan, as defined by the Planning Commission, have been affected by the PL 480 transactions: (a) Miscellaneous Capital Transactions: The starred items in the table above are taken into account by the Planning Commission in arriving at their estimate of net receipts from miscellaneous capital transactions. (b) External Assistance: This item includes amounts corresponding to the releases from the US Title Account (i.e., amounts corresponding to the receipts allocated to the Special Development Fund). - 4j7 - (c) Deficit Financing: The sale of Treasury Bills to the Reserve Bank in order to enable the Government of India to make its payments to the US Title Account is recorded here together with the redemption of Treasury Bills made possible by the sale of PL 480 commodities. What this means in effect is that assistance under PL 480 has only been taken into account as a resource for financing Second Plan expenditures to the extent that funds have been released from the US Title Account for spending on approved projects. - 48 - APPENDIX II TC ANNEX VII Some Notes on Income and Corporate Taxation (1) Structure of income tax and corporation tax The Indian income tax for individuals consists of three elements: a basic tax, a supertax and a surcharge. Both basic tax and supertax are progressive. The basic tax for the part of taxable income over Rs. 20,000 is a flat rate of 25 per cent. The supertax is levied only on the part of taxable income over Rs. 20,000. For very high incomes it amounts marginally to 45 per cent. Including the surcharge (10 per cent of basic tax plus supertax on earned incomes in excess of Rs. 100,000) the marginal rate of income tax on earned incomes goes up to a limit of 77 per cent. The marginal rate on unearned incomes is higher. Taxes on individual incomes are levied "at the source" with respect to salaries (all three elements of the tax) and to dividends and interest on bonds (basic tax and surcharge thereon). Agricultural income is not taxed by the Center, although some States levy an agricultural income tax. No income tax is payable if the income does not exceed Rs. 3,000. In the case of a married person with income not exceeding Rs. 20,000, the first slabs of Rs. 3,000, Rs. 3,300 and Rs. 3,600 are exempt from tax when the individual has no children, one child or more than one child respectively. In the case of individuals who are not married or whose income exceeds Rs. 20,000, the first exempt slab is limited to Rs. 1,000. There are no old age or infirmity reliefs, nor medical reliefs. Earned income is taxed at a rate lower than that applicable to unearned income. This is done by applying certain basic rates to all incomes and by levying, in respect of unearned incomes, a special surcharge of 15%. Corporations also have to pay basic tax and supertax, the difference from the income tax for individuals being that both are levied at flat rates (for Indian companies in most cases 20 per cent and 25 per cent respectively). Some refinements with respect to taxation of Indian corporations are given below: a) Indian public corporations with income not exceeding Rs. 25,000 pay only 20 per cent supertax. b) Indian "closely held corporations" (generally companies which are controlled by a few persons) have to pay an additional supertax of 37 per cent on the whole of their undistributed profits if exceeding 50 per cent of the year's income minus normal tax in the case of an industrial company and 35 per cent in the case of a non-industrial company. (Example: On a profit 100, basic income tax and supertax would amount to 45, leaving a balance of 55. If out of this 55, 20 is distributed and 35 retained, a 37 per cent additional supertax has to be paid with respect to the entire 35 retained). This extra tax is intended to thwart the avoidance of income tax by share- holders through retention of earnings in business. (L Recent changes in taxation of dividends and related changes in taxation of cornorations A new system of taxation of dividends has become effective in respect of dividends declared by companies for accounting years ending after March 31, 1959. In connection with this a number of changes have also been made with respect to taxes to be paid by companies themselves (these changes have become effective as from the assessment year 1960/61, for in this assess- ment year companies are assessed for accounting years ending during the period April 1959-March 1960). Following is a comparison of the old and new tax systems: tal The old system Under the old system most Indian corporations paid something like 56.5 per cent of their profits in the form of income tax, surcharge on income tax, supertax, excess dividend tax and wealth tax (the percentages of excess dividend tax and wealth tax were not constant, but the possible variations in the total percentage of 56.5 were quite minor). In the table that follows the assumption is made that a company distributed under the old system 50 per cent of its profits after tax (i.e. 21.75 per cent of profits before tax). The old system was based on the legal fiction that income tax plus surcharge paid by the company on its profits (31.5 per cent) had been paid by the shareholders on the dividend which they received. Consequently the "gross dividend" received by the shareholders was supposed to have been 100 X 21.75 = about 31.75 100 - 31.5 (This formula for the "gross dividend" is derived as follows. If the net dividend 21.75 is N and the gross dividend is G, G - 315 G = N So, G(l - 315) = N 100 100 So, G 100 N 100 - 31.5 - 5o - This "gross dividend" of 31.75 had to be declared to the tax authorities by shareholders as part of their total income. Company's Profits before Tax: 100 Old system New system Basic tax at 30 per cent 30 Basic tax at 20 per cent 20 Surcharge on income tax at 1.5 per cent 1.5 Supertax at 25 per cent 25 Supertax at 20 per cent 20 Excess dividend tax and wealth tax Sa/ Tax paid by company 56.5 Tax paid by company on 45 its own account Company's profits after tax Company's profits after tax (distributable surplus) 43.5 (distributable surplus) 55 Profits retained by company 21.75 Profits retained by company 21.75 Profit distribution (amount Profit distribution (amount received by shareholder) received by shareholder) e.g. 50 per cent 21.75 55 - 21.75 33.25 Amount of dividend income to Dividend tax paid at source be declared to tax authori- (i.e. withheld by company) ties ("grossing procedure") 30 per cent of 33.25 9.98 100 X 21.75 31.75 100-(30+1.5) Amount of dividend income to be declared to tax authori- Amount deducted by tax authori- ties 33.25 ties from total income tax to be paid by recipient of Amount deducted by tax authori- dividend income (so-called ties from total income tax "tax credit") 31.75 - 21.75 10.00 to be paid by recipient of dividend income 9.98 a/ The wealth tax for corporations was a flat rate of one-half per cent (an amount of assets of Rs. 500,000 being exempted). The excess dividend tax was levied as follows (for public limited corporations): Dividend up to 6 per cent of paid-up capital - no tax; dividend of 6-10 per cent, 10 per cent tax; dividend of 10-18 per cent, 20 per cent tax; dividend over 18 per cent, 30 per cent tax. (On average the excess dividend tax worked out at 2.5 - 3.5 per cent of profits). - $1 - Against this "grossing procedure" the shareholders were allowed to deduct the difference between gross and net dividend (in the table 31.75 minus 21.75, or about 10) from the total income tax they had to pay (the so--called "tax credit"). (b) The new system The essence of the new system is that the procedure of grossing plus tax credit has been abandoned. Instead, the company is now withholding on the dividend to be paid a tax amounting to 30 per cent as the most common case. Thus dividends are taxed at the source. On the other hand a recipient of dividend income (a) has to declare his gross dividend to the tax authorities in connection with the assessment of his total income tax, and (b) is allowed to deduct from the total income tax he has to pay the amount of tax on dividend withheld by the company at the source. As a corollary to these changes the tax rates for the companies themselves were so modified as to produce about the same amount of annual net revenue (i.e., the annual gross revenue obtained from the companies under the old system less the tax credit given to the shareholders). This was done by changing the percentages of basic and supertax and abolishing the surcharge on income tax, the wealth tax (as far as corporations are concerned) and the excess dividend tax. (c) Comparison of old and new system in the table In the table the calculation has been made on the assumption that under the new system the company will wish to plough back the same share of its profits as under the old system (21.75 per cent). In this case the profit distribution can be somewhat larger than under the old system (33.25 versus 21.75), but the total tax receipts of the Government will remain about the same ($6.5 plus income tax of 31.75 minus 10 versus 45 plus 9.98 (dividend tax) plus income tax of 33.25 minus 9.98) and so will be the amount of income from dividend after tax received by the shareholder. (d) Conclusion The recent changes in taxation of dividends and related changes in taxation of corporations have simplified the Indian tax structure but have not brought about any change of importance in the overall tax burden. Nor does the new system offer any inducement to a company to alter its allocation of profits as between dividends and retained profits. In individual cases minor differences are possible; for instance, one company may have paid a little more excess dividend or wealth tax than another. Also some companies did not pay wealth tax at all (e.g. investment - 5 2 4 companies); consequently there are cases (relatively few) where a company can retain only a somewhat smaller share of its profits before tax if it wishes to maintain the dividend after tax at the level reached before the change in the tax system. (3) Tax reductions for enterprises (a) Exemption of basic dividend ("tax holiday") New industrial undertakings are exempt from tax, for the first five years, on profits up to the equivalent of 6 per cent of the capital employed. This measure was introduced in 1949 for undertakings which started manufacturing after April 1, 1948. Originally the concession was available only to undertakings of at least 50 employees, but afterwards it was extended to smaller enterprises. On the basis of present legislation this tax exemp- tion will last until 1966 (i.e. an enterprise which starts production not later than March 31, 1966 will still get the full reduction for five years). Dividends declared by new industrial undertakings out of profits exempt from tax as mentioned above are also tax free. (b) Tax reduction for dividends in case of establishment of new com- panies by existing ones When existin. companies (Indian or non-Indian) establish new com- panies in certain basic industries (enumerated by the law), dividends paid on the shares in these new companies held by the "mother company" are free from supertax. This facility was introduced in 1953 and amounts to a sub- stantial tax reduction. (c) Development rebate This rebate is available to new enterprises and existing ones in case of expansion. It is applied to new plant and machinery and amounts to 25 per cent of the cost (40 per cent in the case of ships). This amount may be deducted from profits (either in one year or spread over a number of years) to determine the amount of profits liable to tax. A firm which takes full advantage of depreciation allowances and also receives the development rebate on a given asset ultimately enjoys tax deductions equal to 125 per cent of the value of the asset. The development rebate is thus a real bonus for new investment. It is available to all enterprises irrespective of the nature of the activities carried on, but is restricted to machinery and plant as contrasted with buildings, offices and the like. This measure was intro- duced in 1955 for an indefinite period. (d) Carrying forward of losses Losses may now be carried forward for eight years. They can be applied against income from any business provided the business in which the loss was originally sustained continues to be carried on. Business losses may also be set off against non-business income, but only for the year in which the loss is incurred. - 53 - (e) Depreciation allowances The main rule regarding depreciation is that it is admissible in each accounting year to a prescribed percentage of the "written down value". The percentage rates have been fixed for individual items or groups of items keeping in view generally the estimated life of each asset. The "written down value" is the actual cost after yearly depreciation. Extra shift depreciation allowances are given for certain types of undertakings and for certain types of machinery which are worked double or multiple shifts. The size of the allowances are dependent on the number of days on which there was more than one shift. (f) Exemption from tax of interest received by foreign creditors and suppliers of capital plant and machinery Interest payable by any industrial undertaking in India on loans obtained from such foreign institutions as are approved by the Government of India, or on moneys borrowed or debts incurred abroad for the purchase outside India of capital plant and machinery on deferred payment terms previously approved by the Government, is exempt from tax. Generally speaking, the important conditions necessary for securing approval of a loan or debt by the Government are that the repayment of the loan or debt is spread over, or deferred for, a reasonably long period - at least 5 years - and that the rate of interest charged by the foreign creditor is reasonable. (4) Rates of tax applicable to income of corporations The following table summarizes the rates of basic income tax and supertax payable by Indian and non-Indian companies for the assessment year 1960/61. Income tax Supertax Total 1. Most Indian companies 20 25 45 2. Foreign public or private companies a) Dividends received from a subsidiary Indian company 20 10 30 b) Dividends received from an Indian company (not being a subsidiary company) regis- tered on or after April 1, 1959 1/ 20 33 53 c) Income other than the dividends mentioned in (a) and (b) above / 20 43 63 1/ When the Indian company was registered before April 1, 1959, the percent- ages for supertax and total tax are 43 and 63 respectively. 2 E.g. income derived by a foreign company from an Indian branch and income from royalties. To interpret this table correctly, the following points-should be kept in mind: (a) The rates mentioned under 2(a) and 2(b) are not comparable to those under (1). The former refer to dividends after the Indian company itself has already paid basic and supertax on its profits on the basis of the rates mentioned under 1 (i.e. 45 per cent). (b) The rates mentioned under 2(c) are not comparable to those under (1) either. Under case (1) revenue will be derived by India from tax paid by the Indian company and from tax paid by the shareholder receiving dividend income from that company. In case 2(c), however, revenue .is derived by India only from the Indian branch (not subsidiary) of the foreign company.2/ (c) In the case of industrial companies, due to various deductions and concessions for the computation of taxable income,the tax-base .to which the rates of tax are to be applied is substantially reduced as compared to the actual earnings or profits determined according to normal conmercial and accounting principles. Consequently the average incidence of tax will be less. (5) Taxation of Indian incomes of foreign individuals Taxation of Indian incomes of foreign individuals (wages,.dividends, etc.) is based on the following formula: "A non-resident assessee has the option of being taxed (a) at rates of income tax and supertax applicable to his world income or (b) at the maximum rate of income tax.2/ELu either supertax on total income at a flat rate of 19 per cent or the effective rate of supertax applicable to the total income, whichever be greater." Thus the Indian law does not place a foreign (non-resident) indi- vidual in regard to personal taxation in any disadvantageous position as against an Indian (resident) individual for, under the option available to him, he would never pay on his income more than what a resident Indian would with the same pattern of Indian and foreign incomes. With respect to foreign technical employees there is an exemption from income tax for a minimum of one and a maximum of three years. The exemption for one year is granted in every case. The exemption for three years is only granted when the contract has been shown in advance to. the 1/ On the other hand, of course, the foreign company may be subject-to addi- tional tax on its income derived from India in the country where it i's based. 2/ The maximum rate of basic income tax for 1960/61 is 25 per cent; in addi- tion there is a surcharge of 5 per cent - total 30 per cent. Indian Government and they have approved a three-year exemption. (When an employee starts work in India on e.g., June 1, he gets his exemption for 2 years and 10 months only, April 1 being the beginning of the fiscal year). Passages for foreigners going on home leave are excluded from their income for tax purposes. Other perquisites of foreigners that are free from income tax include: medical facilities for the foreign employee and his family, refreshments during office hours, recreational facilities for groups of employees, services of gardeners. Moreover, costs of cars and rent of houses furnished by the employer are assessed on a liberal basis. Nith respect to payments of premiums to provident funds and life insurance com- panies exemption is available for income tax up to either Rs. 8,000 or one fourth of the income, whichever is less (this deduction is available for Indians and non-Indians).