Supply-side measures have limitations in boosting capex

A closer look at the production-linked incentive (PLI) scheme, the flagship supply-side measure, will show that it doesn’t support 80 percent of the Indian GDP, but a few dozen large manufacturers. The expectation is that they will pull up smaller manufacturers and suppliers that could supply them with parts and components as well as different types of services. In the process, the whole economy will benefit in terms of higher overall investment and GDP growth rates. However, that model of over-relying on a select few large manufacturers to do everything, support smaller firms, invest in R&D and boost exports, doesn’t seem to be working.

Limited Impact  

There are multiple reasons why supply-side measures are not effective. First, the linkage between large manufacturing firms and smaller suppliers is not as strong as many of us tend to believe. Second, a tariff wall (in essence a demand-side measure to support indigenous manufacturers) ends up becoming a supply-side hurdle by imposing cost inefficiencies on downstream user industries. Thus, blocking imports of cheaper (not inferior quality) Chinese toys may or may not help indigenous toy manufacturers, but it will jack up sourcing costs for domestic retailers, forcing them to raise the selling prices of toys, which in turn will cap their demand. As retail could be more labour-intensive than, say manufacturing, tariff walls lead to a net loss of jobs that further cap demand indirectly in other industries. Similarly, blocking cheaper Chinese supplies used by real estate companies, say, PVC fittings will raise the cost of residential homes, and in turn, will cap the demand for cement and steel. In other words, supply side and demand measures are running counter to each other. To make matters worse, tariff walls make domestic markets more attractive for businesses, leading to neglect of exports, a bigger opportunity that we have been failing to tap for a long period of time.

That is not all. Indian banks, especially the state-owned ones, have a serious “pro-manufacturing and pro-large firms” bias leading to the virtual denial of bank credit to a large chunk of smaller business entities or small and micro enterprises, more so in the case of services supplying firms. The credit appraisal mechanism of Indian banks, especially the state-owned banks, which are supposed to be more inclusive, is more suited to manufacturing firms as they give loans based on collaterals (against plants and machinery, for instance), and not based on cash flows. It disadvantages services firms which tend to be more labour-intensive, while job intensities of manufacturing firms have been declining due to increasing labour-saving automation. India’s slow progressing labour market reforms are not helpful either. Thus, fewer jobs are created per unit of credit disbursement. That cap the growth of consumer demand, and in turn, cap investments from the demand side.

Similarly, other supply-side measures such as slashed corporation taxes don’t apply to non-corporation business entities such as sole-proprietorship, partnership and limited liability partnership firms which make up the majority of businesses in India. That apart, it’s a tax on profit, so it’s irrelevant for companies that  don’t make any profit. In other words, lower corporation taxes don’t help smaller corporations, such as a private limited company providing research services, with say five employees, as most of its revenue (up to 80 percent is spent on paying up salaries that continue to be taxed higher. Besides, a badly designed and poorly implemented indirect tax regime under the goods and services tax (GST) is a big pain for all kinds of smaller business entities.

To sum up, supply-side measures in their current forms don’t seem to benefit a large segment of the Indian economy: smaller businesses in general, and services providers among them in particular. They hamper job creation and in the process cap overall demand for goods and services. That, in turn, caps investment in many more sectors of the Indian economy, including manufacturing. Besides, the tariff wall, a key demand-side measure, by imposing cost inefficiencies on downstream industries and undermining exports turns into a supply-side impediment. That caps overall investment and in turn GDP growth rates.

Ritesh Kumar Singh is a business economist and CEO, Indonomics Consulting Private Limited. He tweets @RiteshEconomist. Views are personal, and do not represent the stand of this publication.