Tentative steps

A significant component of the Finance Bill cleared by Parliament this week has been to lower withholding tax on rupee-denominated government and corporate debt to 5 per cent from 20 per cent for two years starting in June.

This is essentially amounting to slashing interest income that foreigners pay on local bonds. How far it will help government raise more debt and boost the market is doubtful, given that foreign institutional investors are still dithering on upping their investments in core sectors like manufacturing and infrastructure. The rupee has recovered against the dollar over the last three months on falling gold and oil prices, and wholesale price inflation is looking a tad better than this time last month, but overseas inflows into government bonds have been subdued.

Nonetheless, the bare bones of the economy fail to inspire. While government believes that higher capital flows can bridge current account deficit (CAD), with lower withholding tax abetting the process, a huge proportion of these flows ride on unstable debt and portfolio investments, as opposed to stable FDI flows. Not going ahead with the proposed Commodities Transaction Tax is a positive step. But policy initiatives to support capital inflows must factor in ways to encourage FDI flows by liberalising rules and raising investment limits in debt instead of slashing withholding tax without adequate provisos for foreign entities benefiting from lesser tax. While a lower withholding tax on investments in infrastructure, in particular, would lead to greater diversity of Indian bond issuers and improve investor sentiment, the risk of investor concentration would be high. And, any FDI inspired by lower withholding tax would be dependent on greater progress on the policy and reforms fronts.

Tax compliance will pose challenges once withholding tax is clipped, and successive Indian governments have rarely shown willingness to extend their regulatory powers beyond the country’s borders. While lowering withholding tax, the government must put in safeguards to ensure that foreign financial institutions do not eat the cake and the icing too. It should ensure that details of Indian clients of FIs investing in India are made available to it, and if required, impose penalties on entities on their income earned in India if such information is not provided in a timely manner. Such regulation is an obligation even when it comes to wooing foreign investments.