Wednesday, August 24, 2016

Marginal cost of public funds: a valuable tool for thinking about taxation and expenditure in India

by Ajay Shah.

In an ideal world, taxation would be done in a frictionless way. The ideal world is a nice place where there are no transactions costs either for taxpayers in compliance, or for the tax authorities in collection. There would be no illegality and criminality surrounding the tax system. Most important, the presence of taxation would not modify the resource allocation in the slightest.

`Resource allocation' is economist-speak for the magnitudes of labour and capital, and the technology through which they are used. `Technology' is economist-speak for both the science and technology, and the business methods through which resources are utilised. In the ideal world, firms would produce based on pure efficiency considerations. Nothing about the questions `What to produce?' and `How to produce?' would be modified in the slightest by the tax system.

The government would collect taxes in this ideal world without imposing any excessive burden upon society. In other words, the cost to society of Rs.1 of spending by the government would be only Rs.1.

This notion is formalised as the `Marginal Cost of Public Funds' (MCPF). This answers the question: When the government spends Rs.1, what cost does it impose upon society? As with most economics, this question is posed `at the margin', i.e. what's the cost to society of the last Rs.1 that the government spent? In the ideal world, the MCPF is 1, but in the real world, it's always worse (i.e. bigger than 1).

The aspiration to get an MCPF of 1 was precisely expressed by Pranab Mukherjee in his July 2009 budget speech where, in para 31, he says:

I hope the Finance Minister can credibly say that our tax collectors are like honey bees collecting nectar from the flowers without disturbing them, but spreading their pollen so that all flowers can thrive and bear fruit.

This happy destination is one where the MCPF is 1, i.e. where the cost to society of Rs.1 of tax collection is 1.

Why do we get MCPF $> 1$?

Why is it that in the real world, we always have an MCPF that exceeds 1? There are costs of compliance, costs of administration, corruption, illegality, criminality. When all these costs are encountered, the cost to society of Rs.1 of marginal tax revenue exceeds 1.

Most important is the issue of a modified resource allocation. People respond to incentives. If income is taxed, people work less. If apples are taxed, people eat more oranges. This results in a distorted resource allocation, which results in lower welfare i.e. lower GDP. When the act of taxation distorts the resource allocation, and thus reduces GDP, the cost to society of the last Rs.1 of taxation exceeds 1.

There are seven sources of MCPF$>1$ in India:

  1. Income tax distorts the work-leisure tradeoff and the savings-consumption tradeoff.
  2. Commodity taxation distorts production and consumption, particularly when there are cascading taxes.
  3. We in India have a menagerie of `bad taxes' including taxation of inter-state commerce, cesses, transaction taxes such as stamp duties or the securities transaction tax, customs duties, taxation of the financial activities of non-residents. From 1991 to 2004, we thought the tax system was being reformed to get rid of these, but from 2004 onwards, things have become steadily worse, starting with the education cess and the securities transaction tax. All these are termed `bad taxes' in the field of public finance because when money is raised in these ways, the MCPF $\gg 1$.
  4. India relies heavily on the corporate tax, and has double taxation of the corporate form. In the last decade, corporate income tax and the dividend distribution tax added up to 35% of total tax collection. The double taxation induces firms to organise themselves as partnerships and proprietorships.
  5. There is the compliance cost by taxpayers and tax collectors, which is a pure deadweight cost. At the extreme, these include the costs imposed upon society by illegality and criminality owing to corruption in the tax system. When some firms get away with tax evasion, this changes the incentives of ethical firms to invest, which imposes enormous costs upon society as the most ethical firms are often the highest productivity firms.
  6. There are the consequences for GDP of the political economy of lobbying for tax changes, which arise when we do not have simple single-rate tax systems. E.g. if there was only one customs duty (e.g. 5%), this is much better than having different rates. Similarly, 80% of the countries which introduced the GST after 1995 have opted for a single rate GST.
  7. At the margin, public spending is actually financed out of deficits which are deferred taxation, intermediated through the processes of public debt management. Hence, in thinking about the MCPF, we must think about deficits and their financing also. Additional deadweight cost appears here, as we do financial repression (some financial firms are forced to buy government bonds). This is akin to a narrow commodity tax and is a bad tax.

All good thinking in tax policy and tax administration impinges upon the MCPF. If we setup a flawless GST, the MCPF will go down. If we reform tax administration, the MCPF will go down. The distortion associated with a tax goes up in proportion to the rate squared: hence the MCPF will be lower at a GST rate of 12% rather than at 24%.

How big is the MCPF in India?

As the discussion above suggests, there is the assessment of MCPF at the level of society as a whole and there is its measurement at the level of one tax at a time where the `bad taxes' will leap out of the page.

Estimation of MCPF is hard. Computable general equilibrium models are useful for thinking about shifting from commodity specific taxes to a single rate VAT. But most of the elements above are beyond the analytical reach of empirical economics.

One uniquely Indian problem is that on an international scale, most of these problems have been abolished. Most mature economies do not do financial repression, have low corruption in tax administration, do not have political economy of lobbying for tweaking of tax rates, do not have any of the bad taxes (taxation of inter-state commerce, cesses, transaction taxes, customs duties, taxation of financial activities of non-residents). Most mature economies have moved to a commodity neutral VAT or sales tax. As with most parts of the Indian macro/finance environment, India is an outlier with extremely poor institutional mechanisms in taxation. Nobody does the things that we do, and hence there is no international literature which helps us measure the MCPF in India. All we can know is that the Indian MCPF is very large.

Let's look at the international literature. Many papers find values from 1.25 to 2 in OECD countries. For an example of values from advanced economy, Dahlby and Ferede, 2011, find that the Canadian income tax has a marginal cost of public funds of 1.71, their personal income tax yields a value of 1.17 and their general sales tax has a value of 1.11. Feldstein, 1999, estimates a value of 2.65 for the US. Ahmad and Stern, 1984, estimate that the marginal cost of public funds in India for excise is between 1.66 and 2.15; for sales tax it is between 1.59 and 2.12; for import duties it is between 1.54 and 2.17.

When compared with conditions in India, the values seen in these existing papers are small, as the full blown distortions of the Indian tax system are not found in those countries. The one paper on India (Ahmad and Stern, 1984) only addresses a small part of the distortions associated with the Indian tax system. Indian policy thinkers who read Feldstein, 1999, which estimates a value of 2.65 in the US, would be delighted to achieve the conditions described in that paper.

Putting these considerations together, Vijay Kelkar, Arbind Modi and I believe that the true MCPF in India may exceed 3.

Further research on this question is very important. However, we are not able to visualise a research strategy that could put all the seven sources of distortion into one estimate, using today's knowledge of public economics. We are forced to form a guesstimate, and we propose the value of 3.


A central objective for tax reform should be to modify tax policy and tax administration so that the MCPF comes down. A central consideration in expenditure policy should be to narrow expenditure down to the few things where we can be convinced that the marginal gains for society exceed the MCPF, i.e. the last rupee of spending gives benefits to society exceeding the hurdle rate of Rs.3.

Spending on private goods. The value to society of gifting me Rs.1 to buy private goods that I like is Rs.1. Subsidy / transfer programs do not meet the test.

Leakages in private goods. If government intends for person $x$ to be the recipient of a private good of Rs.1, but owing to inefficiencies and corruption, Rs.0.5 reaches person $x$ while Rs.0.5 reaches an unintended beneficiary such as an official or a politician, this still yields gains for society of Rs.1, except that the gains are being allocated differently from what was intended. This does not change the fact that the aggregate gains to society was Rs.1, which is below the threshold of 3.

Spending on public goods. Spending on many public goods does yield gains that exceed the hurdle rate. We spend Rs.400 crore a year on running SEBI which produces the public good of financial markets regulation. SEBI does this poorly, and there are many ways in which SEBI can better utilise this money. But there is little doubt that the gains to society exceed Rs.1200 crore. If you imagined a world without SEBI, Indian GDP would drop by more than Rs.1200 crore.

Similarly, once we build a government agency to control air pollution, this will yield gains to society (in terms of the reduced burden of respiratory illness) vastly greater than the direct expenditures for running the agency. The same can't be said about public spending that makes the private goods of health care for people with respiratory ailments. In anticipation of the October 2016 epidemic of Dengue, let's fight mosquitoes. The gains to society from vector control easily exceed the hurdle rate, while the services of hospital beds and crematoriums are private goods.

Leakages in public goods. With public goods programs, we will sometimes get the situation where inefficiencies in the expenditure profile damage the marginal product to below Rs.3. Sometimes, these can be salvaged by improving spending efficiency. At other times, we should just admit that we have low State capacity in India and shut down the spending program.

How big should the State be? We should increase spending as long as the marginal gains to society exceed the MCPF. As the MCPF in India is high, this implies that the optimal scale of spending in India should be lower. Evaluating the possibility of a large State is the luxury for people who live in countries where the MCPF is low.

The free rider problem with sub-national governments. In India, the dominant source of resourcing of sub-national governments is central funds. In this case, if I am one state in India, it's efficient for me to advocate bigger expenses, as I don't pay the full cost of distortions experienced by the country. My marginal gains from spending one more rupee are mine, while the MCPF is imposed on the full country. To say this differently, Greece always wants more expenditure by the EU. Hence, sub-national governments should not have a say in the overall size of government. This perspective implies that in the new GST Council, the two-thirds vote share of states will generally favour a higher GST rate.

Monday, August 22, 2016

Interesting readings

Who is afraid of algorithmic trading? by Ajay Shah in The Business Standard, 22 August.

Recording each vote by M.R. Madhavan in The Hindu, 22 August.

Creating space for financial services by Varad Pande, Nirat Bhatnagar and Raahil Rai in The Mint, 22 August.

Why we need to stand up for the right to insult religion and beliefs by Sunny Hundal in The Hindustan Times, 21 August.

Repeal the sedition law by Sudeep Chakravarti in The Mint, 19 August.

GST bill a historic landmark but formidable challenges lie ahead by Sudipto Mundle in The Mint, 19 August.

Tata vs DoCoMo: Two warring partners and one big mess by Deepali Gupta and Arijit Barman in The Economic Times, 18 August. Also see earlier work from NIPFP: link, link, and Treat the disease, not just the symptoms by Bhargavi Zaveri and Radhika Pandey in The Business Standard, 10 August.

Farm Policy: The political economy of why reforms elude agriculture by Pravesh Sharma in The Indian Express, 18 August.

Tracing GST's evolution as an idea by M Govinda Rao in The Business Standard, 18 August.

Maharashtra to give land for mandis by Sandip Das in The Financial Express, 17 August.

Fractured lands: How the Arab world came apart by Scott Anderson in The New York Times Magazine, 15 August.

The Tor Project's social contract: we will not backdoor Tor by Cory Doctorow in The Boingboing, 12 August.

App-only bank Mondo just got a banking licence by Oscar Williams-Grut in The Business Insider India, 11 August. In India, life is hard.

"A Honeypot For Assholes": Inside Twitter's 10-Year Failure To Stop Harassment by Charlie Warzel in The Buzz Feed News, 11 August.

Trai & transparency: The irregular regulator by Smriti Parsheera and Bhargavi Zaveri in The Economic Times Blogs, 10 August.

The Sporting Spirit by George Orwell.

National Agriculture Market and the political economy of agriculture marketing by Pravesh Sharma in NIPFP YouTube Channel.

Saturday, August 20, 2016

How can financial regulators combat mis-selling? Five solutions

by Monika Halan and Renuka Sane.
In a previous article (Banks are unfair in their role as financial advisors / distributors), we described our audit study on the sale of financial products across 400 bank branches in Delhi, India (Halan and Sane, 2016). In this paper, we found three things:

  1. Customers are mostly sold insurance products by private sector banks, and fixed deposits by public sector banks, regardless of what they ask for. This suggests that in private sector banks that have high sales incentives, the high commission bearing product is mostly recommended. In public sector banks, where there are deposit mobilisation targets, fixed deposits are mostly recommended. In neither case is there concern about the best interests of the customer.
  2. Complex features of a product such as cost are rarely voluntarily disclosed. This suggests that when customers don't know what they don't know, it is likely that material information will be shrouded.
  3. When bank managers do answer questions on product features, most of the information is either incorrect, or incomplete. This suggests that either managers themselves do not know, or do not care, or deliberately mislead customers.

Regulators around the world, including countries such as India, have responded to problems of mis-sales in retail finance by strengthening consumer protection regulations in the form of disclosure standards, ban on commissions and volume based payments, and suitability requirements in the sale of products. Regulators might require sales staff to disclose product features, but as we show, have little control over whether they are actually disclosed, and importantly, disclosed truthfully. How can financial regulation do better?

Solution 1: Refocus financial literacy upon distributors

The qualitative study of the audit reports showed the lack of financial knowledge of the sellers of these products. For instance, public sector bank managers, whose banks have tie ups with asset management and insurance firms, did not know the basics about the products they were selling. Some others were not even familiar with some product names. Most bank officers were not clear about the costs or other complex features. We also noticed that the more complicated the product, the worse were the disclosures reflecting the lack of distributor education by manufacturing firms. The policy debate in India has always emphasised financial literacy of the customer. We think that financial literacy efforts should be made for distributors, and not just consumers.

For an analogy, before an employee of a financial firm gets a password from NSE or BSE for trading derivatives, that employee must pass an examination which establishes a certain foundation of knowledge about derivatives. The institutional mechanism for these examinations was built by NSE before derivatives trading was launched in 2000. Similar work is required by RBI, to ensure employees of banks have a minimum standard of knowledge about finance.

Solution 2: Align incentives

A front-line staff person, when selling the product that is part of his target, is doing what any rational economic agent will do: maximising his own benefit. One way to ensure that the front-line staff do the right thing by the customer is to redesign the incentives of the front-line seller. Regulations must reshape the incentives so as to align the interests of the product manufacturer, the seller and the customer.

Solution 3: Fix Board accountability

Regulators need to understand that the front line staff is simply responding to incentives embedded in the organisation. These incentives are established by the senior management who report into the CEO. The CEO gets her direction from the Board of Directors. Some large life insurance firms have changed the product mix they offer to investors and have invested heavily in technology to prevent large scale mis-selling of their products because of a push by the board of directors who were concerned about reputational damage to the overall business group, owing to mis-selling of life insurance.

Solution 4: Data in the hands of regulators

The insurance industry has come together to set up a data repository to fight fraud. It has hired Experian to create a fraud monitoring network that will identify potential fraud by screening customer applications. The industry fears a rise in fraud, due to the new regulator rules that prevent them from refusing claims after three years of the policy being alive, no matter if the fraud is proved.

There is a need to up our aspirations for knowledge and research on consumer protection by financial agencies. This requires database building. As an example, in the UK, every financial firm submits data about every retail financial product sale, to the regulator (the FCA), every day. This makes it possible for FCA to watch patterns in product sales. The FCA links up this data to an array of 3rd party databases about individuals and neighbourhoods, and has systems which raise an alarm about potential mis-selling. In India, this requires building the Financial Data Management Centre (FDMC), writing regulations that require electronic submission of this data into FDMC by all financial firms, and then creating research capabilities in financial agencies to use this data as the UK FCA does.

Solution 5: Use mystery shopping

Mystery shopping is an accepted regulatory tool to discover market failure in developed markets. For example, the UK regulator the Financial Services Authority (FSA) in 2005 responded to concerns expressed by the media, consumer bodies and other organizations about the sales process of the payment protection insurance (PPI) by commissioning a mystery shopping exercise. A mix of phone calls and face-to-face audits got shoppers to pose as customers looking for a particular financial product. 32 of the 52 shoppers felt that they received 'limited information' about the PPI product.

The results of these exercises helps feed into regulatory action. PPI mis-selling cost banks millions of pounds in return of premium and in compensation. The no-commission structure of the UK retail finance market has partly emerged out of evidence gathered through such exercises. Indian regulators need to use such exercises to prevent tick-box regulatory compliance practiced by financial services firms. Such mystery shopping projects must be done using the resourcing of the State; it should not require researchers like us to fund-raise for and manage these research projects.


Indian policy makers have long bemoaned the fixation of the Indian household with gold. They need to look at the attraction to gold and real estate as a vote of no-confidence on the financial sector because of the recurrent scams in the market and obvious regulatory failure in preventing even regulated firms in cheating households of their savings - as was seen in the ULIP scam (Halan, Sane and Thomas, 2014). A fair market place in retail finance that works for all the three participants - the manufacturer, the distributor and the buyer - will transform the Indian financial market. The savings rates of Indian households are very high, but only with better consumer protection will we get large-scale participation by households in the formal financial system. The policy proposals of this article are aimed at building this trust, while having the dynamism of the market economy. They are part of the larger project of putting consumer protection at the heart of financial regulation.


Halan, Monika, Renuka Sane and Susan Thomas (2014), The case of the missing billions: Estimating losses to customers due to mis-sold life insurance policies, Journal of Economic Policy Reform, October 2014.

Halan, Monika and Renuka Sane (2016). Misled and mis-sold: Financial misbehaviour in retail banks? NSE-IFF Working paper.

Monika Halan is a consulting editor, Mint, and a consultant at NIPFP. Renuka Sane is a researcher at the Indian Statistical Institute, Delhi, and a visiting fellow at IDFC Institute.

Saturday, August 13, 2016

Banks are unfair in their role as financial advisors / distributors

by Monika Halan and Renuka Sane.

A major weak link in financial regulation in India is the lack of emphasis on consumer protection. An academic literature on this subject has been building up. The policy discourse has also shifted considerably, and the contours of the policy research and action program are now visible.

For many years, regulators were in denial about these problems. This has started changing. A committee formed by the insurance regulator on the sale of insurance products through banks has also admitted to mis-selling through banks (IRDA, 2011). More recently a circular on August 1, 2016 by IRDA (IRDAI, 2016) has warned banks and corporate agents to stop mis-selling life insurance policies.

The key questions for the research community are about obtaining objective evidence about the problems in the field of households and finance, which can then feed into the work program on financial sector policy. A key missing link in this is an understanding of how sales actually take place.

In a financial product, a critical aspect of the sale is the disclosure made at the time of sale since the product is invisible and the moment of truth of the product can be far into the future. Regulators might require sales staff to disclose product features, but have little control over whether they are actually disclosed, and importantly, disclosed truthfully. There is weak evidence about whether agents intentionally or otherwise make mistakes in the disclosures. This can have large consequences, especially in environments such as India, where financial literacy is low, and regulatory enforcement is weak.

Financial products are sold through many channels in India. Understanding the sale of financial products through the banking channel is important for three reasons:

  1. There has been a rise in third-party distribution through the banking channel. In 2014-15, of the top ten mutual fund distributors on the basis of commissions earned, six were banks (Barbora and Viswanathan, 2016). In the case of insurance as well, banks had the largest share of new business premium for private insurance companies, though the state owned insurer continues to be agency dependent for sales. For example, banks became the largest sales channel for private sector life insurance companies by financial year 2015. The share of first year premium from banks rose from 33.21% in 2010-11 to 47.37% in 2014-15 for the private sector insurance companies. Commissions from sale of third-party products contribute substantially to bank profitability (Balaji and Bhaskaran, 2015).
  2. A 2013 Gallup Poll showed that 70% of the Indians polled said they trusted banks. The answer was 13% for Greece, 27% for the UK and 37% for the USA. Depositors' trust in the basic banking function is being carried over when buying third party products through banks such as mutual funds and insurance.
  3. Recent financial inclusion efforts in India, such as the Jan Dhan Yojana, or the Suraksha Bima Yojana and the Jeeven Jyoti Bima Yojana are being made through the banking channel. Instead of improving access to finance, a bank led sales strategy, if it consists of mis-selling, may result in driving customers further away from it. 

A new audit study

In Halan and Sane (2016), we conducted 400 audits of the sales process of retail financial products in banks in Delhi, India. This is done by sending auditors into bank branches where they claim to be walk-in customers. Neither the auditors, nor the bank managers knew the true motivation behind the study, or the choice of questions.

We investigate what financial products are being recommended by bank managers to walk-in customers. We also study the kinds and veracity of disclosures made in the process of sale. Specifically we ask:

  1. What products do bank based managers recommend? How does this vary when the auditor makes a specific request vs. when the auditor appears uncertain? Are auditors who make specific requests, and are more certain of their requirements able to purchase the product of their choice?
  2. What product features get disclosed? Do the more salient attributes of a product, such as returns, get disclosed more frequently, while complex product features such as costs, or charges on early exit get shrouded?
  3. Are these disclosures accurate?
  4. What might the drivers of product recommendations be? When remuneration is tied to sales-linked bonuses, are the most expensive products sold?

We vary our audits to include informed and uninformed customers with different amounts to invest. An informed customer in the research design requests for the Equity Linked Saving Scheme (ELSS), which is an open-ended diversified equity mutual fund with a three year lock-in. In other cases, the customer (the auditor) acts uninformed, and displays a vague sense of wanting some tax-saving product, but does not know which one. We also vary the amount available for investment. In some cases the request is for investing Rs.25,000 in either the ELSS or a tax-saving product. In other cases the amount to be invested is Rs.100,000.

In an ideal world what would we see? In the ideal world, bank managers will sell the product requested by the customer (in the case of the ELSS) either because it is a sound investment or because they are merely acting as distributors of the product and not as financial advisors. When the customer does not have a view on the product, the bank managers should make an effort to sell the more suitable product, or at the very least show all possible products so that the customer can make an informed choice. If, on the other hand, bank based advisors are not working in the interest of the customer, they will try to steer both types of customers towards the product of their choice.

Bank managers should provide correct and complete information about a product to the customer, especially because SEBI, IRDAI and RBI have regulations that require such disclosures. We, therefore, also study the kind of product features that get disclosed in the process of sale, and the veracity of these disclosures. Our focus is on the following aspects: a) Returns, b) Guarantees, c) Costs, d) Lock-in period and e) Optimal holding period.

A criticism against the ELSS as the choice of the ``sophisticated'' investor is that it is a market linked product, and it is likely that for many investors a guaranteed product such as a fixed deposit or an insurance plan is more appropriate. While there is merit in this argument, our evaluation of product recommendations does not really rely on the ELSS being the optimal product. If bank managers feel that the ELSS is not the most suitable product, then we should see this in the conversations they have with the auditors, as well as the recommendations they finally make. The focus of the experiment is not so much about which is the better product, but about the process in which a product is sold.


Our experiment shows the following:

  1. Bank managers don't really make an effort to understand the client. Managers in public sector banks are less proactive in understanding the client and exert less effort.
  2. Overall, fixed deposits were the most recommended product (51% of the cases), followed by insurance (35%) and mutual funds (8%). When auditors did not have a specific product request and asked for any tax-saving product, mutual funds were recommended 2% of the time, while fixed deposits and insurance were recommended 53% and 36% of the time respectively.
  3. In private sector banks, where internal incentives are around commission income, the high commission product (i.e. insurance) is recommended most of the time (almost 75%). In public sector banks, where there are deposit mobilisation targets, fixed deposits are recommended (almost 72%).
  4. Of those who requested an ELSS product, only 14% were encouraged to buy it. 30% were actively discouraged, and 55% were presented with a neutral response. However, in 71% of the cases where the bank manager was neutral to the ELSS product in the beginning, our auditors later noted that the manager steered the conversation to other products, resulting in a product recommendation different from the ELSS.
  5. This seems to be because in several cases the bank managers themselves do not know what an ELSS is.
  6. Managers seem to be overly concerned about our auditors having to deal with risk in their portfolio in the context of the ELSS. However, a large proportion of the recommendations were ULIPs, which are also market linked or towards participating insurance plans, that too are partially market-linked.
  7. Voluntary disclosures concentrated around returns and guarantees. Customers were never made aware of the costs of the product, if they did not ask a question about costs.
  8. A large proportion of the disclosures were incorrect, when tested against actual information in product brochures or actual past returns.
  9. This suggests a market with two extremes. The private sector prescribes the most expensive products, while the public sector prescribes the least effort default product. In either case, unbiased financial advice in the interest of the customer seems to be missing. This is reminiscent of the situation of health care in India - where the private sector makes more of an effort and prescribes more drugs (often to the detriment of the patient), while the public sector does less of both (Das and Hammer, 2007). 


We find that in private sector banks, where staff have high sales incentives, the high commission product is recommended. In public sector banks, where there are deposit mobilisation targets, fixed deposits are recommended. We also find that the more complex features of a product, such as costs and optimal holding period, are very rarely voluntarily disclosed. When specifically requested, information provided is inaccurate or incomplete.

It is possible that bank managers themselves do not know the product features to be able to disclose them correctly, or that they perceive that customers are impatient and do not want to listen. However, if regulations require managers to make disclosures, then their own ignorance, or inability to engage with an impatient customer require regulatory attention.

Our results point to the difficulties in the use of disclosures for achieving better consumer outcomes. Even if disclosures are made mandatory on product brochures, it is unlikely that they get conveyed to the customer in the correct manner. Regulators have taken the view that since the customer has signed on the documents, the customer is responsible for the purchase. The problem is made worse due to the lack of fixing responsibility on the sales channel for mis-sold products. Unless there is a mechanism of enforcement, a disclosure policy is unlikely to help achieve better outcomes.

Households are not being treated well by Indian finance. Much more needs to be done by way of the academic research agenda and the policy research agenda.


Balaji, Kavya and Deepti Bhaskaran (2015). Why banks resort to misselling. Mint, 22 December 2015.

Barbora, Lisa Pallavi and Viviana Vishwanathan (2016). Tough to separate sales from advisory. Mint, 28 April 2016.

Das, Jishnu and Jeffrey Hammer (2007). Money for nothing: The dire straits of medical practice in Delhi, India. Journal of Development Economics 83, pp. 1-36.

Halan, Monika and Renuka Sane (2016). Misled and mis-sold: Financial misbehaviour in retail banks? NSE-IFF Working paper.

IRDA (2011). Report of the Committee on Bancassurance. Committee Report. Insurance Regulatory and Development Authority

IRDAI (2016). Complaints of Misselling /Unfair Business Practices by Banks/NBFCs, Ref:IRDA/CAGTS/CIR/MSL/152/08/2016

Monika Halan is a consulting editor, Mint, and a consultant at NIPFP. Renuka Sane is a researcher at the Indian Statistical Institute, Delhi. We thank the NSE-IFF initiative on household finance for funding.

Monday, August 08, 2016

Interesting readings

How to build tax administration by Shubho Roy and Ajay Shah in The Business Standard, 08 August.

The limits of vengeance by Pratap Bhanu Mehta in The Indian Express, 30 July.

Dengue should be prevented and not merely tackled when the epidemic sets in by Ila Patnaik in The Indian Express, 30 July.

The State in Business and the Business of Regulation by Bhargavi Zaveri in The Economic and Political weekly, 30 July.

1MDB: The inside story of the world's biggest financial scandal by Randeep Ramesh in The Guardian, 28 July.

What Stalin's Great Terror can tell us about Russia today by James Harris in The Conversation, 28 July.

Sebi, a child of the 1991 reforms, needs reform by Mobis Philipose in The Mint, 26 July.

Sunday, July 31, 2016

CAG concerns about public debt management

by Radhika Pandey and Bhargavi Zaveri.

The CAG report on public debt management tabled in Parliament on 26th July, 2016, has made several adverse observations on the current state of public debt management in India.

  1. It found the legal framework governing public debt lacking in several respects. The present legal framework on public debt does not define basic concepts such as 'public debt', does not indicate the objectives of public debt or the purposes of borrowing. It does not require the formulation of a strategy for the management of public debt.
  2. Over the past two decades, all expert committees have recommended setting up a public debt management agency (PDMA) for performing the debt management function. However, except for a middle office (which also does not perform the functions assigned to it), no progress has been made on this front.
  3. There is no entity that performs functions relating to the external debt of the Central Government such as analysing and monitoring risks and assessing the performance of debt managers against strategic targets or benchmarks.

Apart from the desire of the government to make more-than-incremental reforms, there are two other reasons why it is an opportune time to resume the long-delayed work of reforming the framework for public debt management in India. One, RBI has formally adopted inflation-targeting as the objective of its monetary policy, which heightens the conflict of interest between its role as the investment banker for the Government and the inflation target. All mature market economies separate debt management from monetary policy. As an example, the IMF guidelines on public debt management have emphasised that there should be separation of debt management policy and monetary policy objectives and accountabilities.

Two, RBI has formulated a road map for progressive reduction in SLR (the funds that banks are forced to keep invested in government securities). The SLR is proposed to be brought down by 0.25% every quarter till March 31, 2017. Reducing this `financial repression' is a good thing. But simultaneously, this makes life more difficult for public debt management. We need new institutional arrangements alongside breaking with the old, distortionary ways. Greater diversification of the investor base of government securities, in the quest for voluntary buyers, is required. The cosy arrangements of today for debt management and the bond market will not work in the emerging world.

It is poor policy analysis to proceed with inflation targeting, but not give the central bank the tool of a liquid bond market through which the inflation target will be achieved. It is poor policy analysis to  reduce financial repression, but not plan for the complexities of public debt management in that new environment. This article summarises the problems with the prevailing framework on public debt management in India and sketches the broad countours of a stand-alone law that should govern the same.

Problems with our public debt management framework

  1. The elephant in the room is the lack of an independent public debt management agency (PDMA). This has formed the subject of much discourse in academic and policy circles. From the mid 1990s onwards, all expert committees in India have advocated setting up the PDMA. A recent IMF Working Paper on designing legal frameworks for public debt management has advocated ``centralisation of all debt functions in one single unit to reduce fragmentation and enhance coordination in debt managment''.
  2. When a principal engages an agent to undertake a specific task, the contract between the principal and agent must be tight enough to build in accountability, performance measures, and at the same time allow the agent to perform its task without interference in transactions. While there is a lot of talk of "independence" for government agencies in India, this needs to shift to a mix of accountability on performance and autonomy on transactions. The current legal framework dealing wth public debt management in India is scattered across several laws such as the RBI Act (which obligates the Central Government to entrust the debt management function to the central bank), the Government Securities Act, 2006 (which deals with manner in which RBI will hold government securities, terms and conditions of government securities, etc.) and the Public Debt Act, 1944 (which continues to apply to Jammu and Kashmir). None of these laws codify performance measures or build accountability mechanisms for the agent to perform its task.
  3. As the RBI only deals with marketable debt, a single repository containing all the data which is required for an overall picture of the outstanding liabilities, including contingent liabilities, of the Central Government is not available. As this information is absent, it is not possible to formulate or implement a strategy for public debt management. What we do in public debt management is all transactions and no strategy.
  4. Market infrastructure for the government bond market (the exchange and clearing house) is owned and managed by RBI. The weaknesses in how this management is done has been an important source of failure in bond market development. Decisions about the appropriate market infrastructure for government bonds are best placed at the PDMA, which would be accountable for delivering low cost financing for the government, and would thus have the incentive to think about how to organise these markets.

What should a law governing public debt management look like?

The Financial Sector Legislative Reforms Commission (FSLRC) which recommended the establishment of a PDMA also drafted the blueprint of a law, the Indian Financial Code, that will govern its functioning. The key elements of the Indian Financial Code governing the functioning of PDMA are summarised below:

  1.  It defines 'public debt' to mean internal and external borrowings of the Central Government. This would ensure that there is one single entity that has an overall picture of the outstanding liabilites of the Central Government, both internal and external.
  2.  It codifies the objectives of the PDMA, namely, to minimise the cost of raising and servicing public debt over the long term and to keep the public debt within an acceptable level of risk at all times. For the first time, the manager of the public debt has clearly defined objectives which also translate into measures by which its performance may be judged.
  3. It entrusts the management of existing and contingent liabilites on the PDMA. This ties in with the requirement of having a single manager who will manage all outstanding liabilties of the Central Government. The concrete output will be a single repository of liability-related information.
  4. It codifies the relationship between the principal (Central Government) and the agent (PDMA, as the debt manager) in precise terms. For example, it obligates the PDMA to formulate an annual debt plan and a medium term (three year) debt plan, get the same approved from the Central Government and then implement it. The law also codifies detailed requirements for publication of the debt plan as well as a calendar for issuance of government securities.
  5. It obligates the PDMA to foster a liquid and efficient market for government securities. It empowers the PDMA to advise the Central Government on market design and allow equal access to this market, as an integral part of this market design. Contrast this with the existing framework which is lacking in details on the market structure for government debt.
  6. The entire machinery of governance, such as annual reports of defined standards, performance evaluation, external audits, etc. have been made applicable to the PDMA.


A short while ago, this work was done, but then it was rolled back. The Finance Bill, 2015 tabled in the Parliament proposed the establishment of a PDMA and its functioning broadly on lines described above. Subsequently, the reform was rolled back with a promise that the "...Government in consultation with RBI, will prepare a detailed roadmap separating the debt management functions and market infrastructure from the RBI, and having a unified financial market." It is a big missing link in the Indian reforms.

The authors are researchers at the National Institute for Public Finance and Policy.

Monday, July 25, 2016

Interesting readings

How to regulate professions by Ajay Shah in the Business Standard, 25 July.

Sebi needs a new regulatory structure by Pratik Datta in the Business Standard, 23 July; this analyses and proposes solutions to the recent news:  Sebi snafus make it sitting duck for SAT by Pavan Burugula in the Financial Express, 22 July.

Players and playing fields in the Internet age by Ajay Shah on Medianama, 18 July.

No bridges over troubled waters by Alok Gupta in the Thirdpole, 18 July.

Cheaper flights and scientific collaboration by Christian Catalini, Christian Fons-Rosen and Patrick Gaule in VoxEU, 16 July.

It's time for new regulations to protect clients from sly lawyers by Pratik Datta in the Economic Times, 16 July.

Medical Malpractice around Legally Defined Code of Conduct for Medical Professionals by R. K. Sharma in NIPFP YouTube Channel.

Govts must explain, explain, explain. Potential beneficiaries of reforms are unorganised, they don't know they will ultimately benefit: Arun Shourie by Shaji Vikraman in the Indian Express, 13 July.

Consultation Paper on Proliferation of Broadband through Public Wi-Fi Networks by TRAI in The Telcom Regulatory Authority of India website, 13 July.

Farm marketing reforms: Not in NAMe alone by Pravesh Sharma in the Indian Express, 30 June.