In the earlier article in this two part series, I touched upon the fact that India’s micro, small and medium enterprises (MSMEs) are not performing up to their potential, in large part due to a stifling legal and regulatory environment and poor access to capital. I rued the fact that the government is not an enabler of business activity, but in fact, an impediment to it.
In this article, let us examine the ways in which policy makers can change all this and enable our entrepreneurs to generate wealth, jobs and economic value.
1. Reformation of the system around regulation and compliance
As I mentioned earlier, the government makes companies jump through hoops to register companies and get the necessary approvals to start operations.
As a result, only about 1.6 million out of the ~48.8 million MSMEs in India are formally registered and lose out on access to capital (e.g. bank loans, tax benefits), technology and growth opportunities (Sources: Zinnov, Abdul Naser et al). In fact, a study by the Imperial College Business School found that for every one registered business in India, there are 127 unregistered businesses. As a consequence, the government loses out of a tremendous amount of tax revenue.
A great way to encourage small businesses to register themselves with the government and join the economic mainstream is to reform the system to make company registration and obtaining approvals simple, quick and automatic. Concrete steps in this direction could include:
a. Computerisation and automation of the processing of routine procedures like the name registration of companies, tax registration (obtaining PAN numbers, TAN numbers etc.), labour registration etc. At present, there is a lot of human intervention in these procedures, thus slowing down the process substantially and forcing businesses to incur “incidental expenses” at government offices on a regular basis.
b. Exemption of MSMEs below a certain size from stifling regulatory requirements: How much sense does it make for a software startup employing two people in an apartment or a “pan-shop” employing two people to pay a chartered accountant INR 50,000 (approx. US$ 830) every year to file annual returns and audited accounts? How many small businesses actually comply with these regulations and how much tax revenue is lost due to the resulting non-compliance?
Singapore has a novel way of dealing with this problem. All businesses with revenues less than SG$5 million (US$ 4 million) are exempt from filing audited accounts and from complying with several regulations. This greatly simplifies regulatory compliance and results in a win-win situation for businesses and the government. Don’t you think it is high time for India to consider such a system?
Bringing unregistered businesses into the mainstream economy
2. A massive drive to register unregistered businesses
Remember the Voluntary Disclosure of Income Scheme (VDIS)? In 1997, this scheme gave tax-defaulters the opportunity to pay taxes on undeclared income and therefore convert “black money” into “white money” and avoid the risk of future prosecution. According to the (then) Finance Minister, the scheme yielded INR 10,050 crores (approx. US$ 2 billion) in tax revenue — a phenomenal amount of money in 1997.
While the non-registration of a business is not a serious crime, if there were a scheme to allow unregistered businesses to register in a “fast-tracked” manner and comply with simplified regulations, it would not only give these businesses better access to capital (bank loans/tax benefits/government grants etc.) and growth opportunities, but also bring in a tremendous amount of tax revenue for the government in the long run.
The key is to give business owners the feeling that it makes business sense to comply with regulations and to give them the confidence that they will not be harassed by government officials.
3. A business-unfriendly taxation regime hinders economic activity, hurts job creation and stymies wealth generation. Ironically, a business-unfriendly regime also results in lower tax revenue (due to non-compliance). The following steps are likely to give an impetus to MSMEs and maximise tax revenues for the government in the long-run.
a. Abolishing of the “startup tax”
One of the worst legacies of the UPA II government is what is colloquially referred to as the “startup tax”. Introduced by the same Finance Minister who introduced “GAAR” and retrospective taxation, “startup tax” refers to the tax that startups have to pay (at the rate of 30 per cent) on angel investments received at a valuation that is higher than the face value of a company’s shares (Reference: Union Budget- 2012-13) — which in several cases is almost the entire investment. Deepak Shenoy eruditely explains the mechanics of the ‘startup tax’ and aptly observes, “All it does is to give a tax officer unlimited discretion on a tax that isn’t logical, and that will prompt those that are corrupt to demand bribes in order to approve legitimate valuations.”
b. Provision of tax exemptions for investments into small businesses
Tax exemptions encourage investments into small businesses, and therefore help create jobs for Indians, tax revenues for the government and wealth for the country. It makes economic sense to incentivise investment into small businesses. Therefore, countries all over the world do so. For example, the US allows 100 per cent tax exemption on capital gains income from investments in startup companies. It also allows roll-overs on investments in small businesses and permits 100 per cent write-offs from the total taxable income on investment losses (up to US$50,000). Similarly, Singapore allows deductions of up to 50 per cent of the money invested by angels into small businesses (up to SG$250,000 ie. approx. US$20,000).
Unfortunately, India doesn’t provide angel investors or venture capitalists any serious incentives to spur investments into small businesses. Venture capital funds and registered angel funds are given “pass through” status, meaning that profits from investments are not taxed at the fund level, but only once they are distributed to the angel investors/general partners of the VC fund. While this does avoid double-taxation, there is no real incentive to take risks and invest in businesses.
Isnt’ it time India allowed angel investors and venture capitalists tax exemptions on investments into small businesses?
4. Incentivisation of lending to MSMEs
Expansion of the Credit Guarantee Scheme to make collateral-free loans available to small businesses
As noted in the previous article in this series, the Credit Guarantee Scheme (CGS) works along the lines of the US’s Small Business Administration’s schemes that guarantee a large portion of loans made by banks to small businesses. This encourages bank lending to MSMEs. Unfortunately, the CGS only manages to guarantee about INR 13,784 crore i.e. 0.59 per cent of the total credit demand of MSMEs. In comparison, the SBA guaranteed about US$30 billion ( approx. INR 1, 80,000 crore) in loans or roughly 13 times the amount guaranteed by CGS.
While it is true that the US economy is much bigger than the Indian economy, it is also true that in a high-interest rate and relatively risk-averse environment like India’s, credit is much harder to obtain and therefore, such schemes are all the more necessary.
5. Incentivisation of skill development, training and technology upgradation
Ironically, India simultaneously faces a massive shortage of skilled workers as well as a glut of under-employed workers. At 3.8 per cent, India’s unemployment rate looks very good. However, most of India’s workers are unskilled workers earning very low wages and doing low-value work. This is reflected in India’s low per-capital income which, according to the World Bank, stands at about US$1,165 p.a. A two-pronged approach is required to address this issue:
a. Incentivisation of the training of unskilled workers through tax credits to hiring companies
India needs skilled low-tech workers and simply does not have enough of them. The National Skill Development Council estimates that India will need about 250 million skilled workers in the manufacturing and services sectors by 2022, of which an additional 35 million skilled workers will be required in the auto industry, 33 million in the building and construction space and 26.2 million in the textiles and clothing industry. One cannot have businesses running factories without skilled workers to operate equipment and machinery.
One way to address this issue is to give hiring companies tax credits to help offset the cost of training unskilled workers. This would spur hiring and help workers and companies move up the value chain and therefore lead to higher tax revenues in the long-run.
b. Incentivisation of soft-skills training through tax credits to “high-tech workers”
India produces roughly 5 million fresh graduates every year, of which, 50 per cent are unfit to be hired. NASSCOM rues that only 10-25 per cent of IT graduates produced in India are readily employable. Most of these issues stem from the poor communication skills and English language skills of graduates. It is also widely accepted in the industry that most graduating engineers simply do not have the engineering/software skills to work in the industry without a fair bit of training. Large software companies like TCS, Infosys and Wipro spend up to one year on training their new hires from Indian colleges. They teach them everything ranging from email writing, time management and software design to basic programming — most of the stuff that you’d expect an engineering graduate (especially a computer engineering graduate) to know. Have you heard of Microsoft or Google doing something similar in the US or the UK?
While soft-skills such as communication and time management might not sound like “skills” in the traditional sense of the word, these are exactly what our “high-tech” labour force needs. Tax-credits given to students and fresh graduates who take up soft-skills training would greatly to help them afford such training and become more employable. These workers will eventually join the pool of skilled labour, thus boosting the entrepreneurial eco-system and the economy.
The small business community has high expectations from the 2014 Budget. Let us hope that the Finance Minister sets the country on the path to prosperity by taking at least a few steps to reform the broken ecosystem around small businesses.
First published in The Economic Times. Republished with permission.
The writer is an entrepreneur, investment professional and political consultant. He blogs at http://ashwinianand.wordpress.com and tweets at @ashkronos.
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