Inspections help in the formalization of informal firms

de Andrade el al. (2013) find that “informal firms will not formalize unless forced to do so, suggesting formality offers little private benefit to them. But the tax revenue benefits to the government of bringing firms of this size into the formal system more than offset the costs of inspections.”

Abstract from the paper:

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Many governments have spent much of the past decade trying to extend a helping hand to informal businesses by making it easier and cheaper for them to formalize. Much less effort has been devoted to raising the costs of remaining informal, through increasing enforcement of existing regulations. This paper reports on a field experiment conducted in Belo Horizonte, Brazil, in order to test which government actions work in getting informal firms to register. Firms were randomized to a control group or one of four treatment groups: the first received information about how to formalize; the second received this information and free registration costs along with the use of an accountant for a year; the third group was assigned to receive an enforcement visit from a municipal inspector; while the fourth group was assigned to have a neighboring firm receive an enforcement visit to see if enforcement has spillovers. The analysis finds zero or negative impacts of information and free cost treatments, and a significant but small increase in formalization from inspections. Estimates of the impact of actually receiving an inspection give a 21 to 27 percentage point increase in the likelihood of formalizing. The results show most informal firms will not formalize unless forced to do so, suggesting formality offers little private benefit to them. But the tax revenue benefits to the government of bringing firms of this size into the formal system more than offset the costs of inspections.

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NEPAL: Major highlights of IMF’s 2014 Article IV report

Last week the IMF published a report based on its Article IV consultations in Nepal. The report is a useful document especially for update on overall macroeconomic performance, financial sector highlights and debt sustainability analysis.

Below are major highlights of the report:

• Despite efforts to accelerate public spending, capital expenditure remains low.
• Monetary policy in FY2014 remained loose.
• Non-transparent implicit subsidies to NOC and NEA continued.
• Macroeconomic outlook is broadly stable with 5% growth rate in FY2015.
• Current account surplus may decline as remittance growth slows.
• Medium-term prospects depend on improvements in investment climate— increase in capital spending to crowd in private investment, structural reforms in financial sector, and telecommunications, competition, labor market and business regulation reforms.
• With limited global financial markets, external risks to outlook come mostly from the developments in the Indian economy.
• Exchange rate appears broadly in line with fundamentals. But remittances are skewing domestic activities to non-tradable sand contributing to reducing the competitiveness of agriculture and industry.
• The peg to the Indian rupee serves as a transparent anchor. An “engineered depreciation” or devaluation against the Indian rupee would in the short run likely to lead to additional remittance inflows, boosting international reserves and liquidity. But it would also trigger inflationary pressures. REER has broadly appreciated, but bilateral REER with India has depreciated by over 6% over the past decade.
• Excess liquidity has undermined the conduct of monetary policy. NRB’s success have been modest in reducing this.
• Directed lending to productive sectors forces banks to look for new investment opportunities. Cap on the spread between lending and deposit rates forces banks to improve efficiency. But, policies to direct lending and cap interest rate spreads are of limited effectiveness and can have unintended effects. Hence, it is better to review, modify and eventually phase them out.
• Harnessing the financial sector and remittances to support economic growth is challenging.
• Monetary policy should focus on controlling the volatility and level of excess liquidity in the banking system. It may require: (i) stepping up sterilization, and (ii) raising required reserves. The short-term fluctuations in excess liquidity is partly caused by uneven capital spending.
• Monetary policy cannot compensate for the lack of infrastructure and other structural impediments to growth.
• An interest rate corridor would further strengthen monetary management—limit interest rate volatility, facilitate liquidity management, and improve monetary policy transmission. Also would help in reducing interest rate differential with India and reduce incentives for capital flight.
• Despite a large increase in bank branches over the last decade, access to finance remains limited.
• Financial Sector Assessment Program (FSAP) identified significant financial sector vulnerabilities:
  • Bank supervision is largely compliance-based, fragmented and under resourced.
  • NPLs are likely underreported and widespread ever-greening.
  • Unsupervised cooperatives growing rapidly— partly fueled by directed lending practices

DSA 2014: Nepal is at low risk of debt distress

The latest IMF-IDA debt sustainability analysis (DSA) shows that Nepal faces a low risk of debt distress. In 2012 DSA, Nepal was categorized as facing moderate risk of debt distress. At the outset, the DSA is used mainly by multilateral development banks to determine if a low income country needs either concessional/soft loans only or grants only or a combination of both. They conduct country economic, social, policy and institutional reform and capacity assessments independently and the resulting composite score (threshold) is ultimately evaluated against the various debt scenarios/simulations and the corresponding debt distress classification. Now that Nepal has been categorized as facing low risk of debt distress, multilateral development banks might move to providing concessional/soft loans only (and the allocations/commitments may increase depending on the public expenditure performance of the country).

Nepal’s public debt is about 30% of GDP, almost half of the level held a decade ago. The low risk of debt distress is attributed mainly to the reduced estimates of the cost of a potential financial sector shock and the increase in the discount rate used (5% for all LIC DSAs). This was underpinned by prudent fiscal policy and low execution of capital expenditure budgets. The low debt distress also means that Nepal has plenty of room to boost capital expenditure (or fiscal space) despite running a modest fiscal deficit.

Highlights from the DSA July 2014:

• Under the baseline scenario, Nepal’s external debt indicators remain well below indicative sustainability thresholds. Under the baseline, the ratio of public debt to GDP rises modestly by the end of the projection period.
• Debt dynamics remain resilient to standard shocks. These stress tests include shocks to GDP growth, exports, non-debt creating flows, and a combination of these shocks, as well as a onetime 30% nominal depreciation shock in 2015 (the most extreme shock).
• Under the most severe shock (to non-debt creating flows, capturing a remittance shock), the PV of debt to exports + remittances rises rapidly over the next 2 years but stays below the threshold, and thereafter declines again, while all other indicators remain well below the thresholds.
• In the context of the PV of public debt-to-GDP ratio, the most extreme shock is a 30 percent one-time depreciation in 2015, which does not lead to a breach of the threshold.
• The 10 percent of GDP increase in debt creating flows shock mimics a financial sector shock leading to domestic debt-financed bank  recapitalization needs. The recapitalization needs for the entire banking sector (public and private) from a financial sector shock in which nonperforming assets increase by 2 percentage points (implying a 50 percent increase) could amount to 4¾ percent of GDP.
• Contingent liabilities arise mainly from the operations of state owned enterprises (SOEs), and rising pension costs need to be addressed to head off future risks.

Overview of Nepal’s FY2015 budget

Here is brief snapshot of the FY2015 budget, which has rightly focused on two fundamental issues: (i) public infrastructure investments, and (ii) enacting new Acts and amending existing ones to accelerate public expenditure and to attract private sector investments. However, given the coalition government and its constraints, understandably the budget could not give much attention to rationalization of expenditures.

The total planned outlay is NRs618.1 billion, of which 64.5% is recurrent, 18.9% is capital and the rest 16.6% is financial provision. The total expected revenue is NRs497.3 billion, of which 85% is expected to come from revenue mobilization, 14.8% from foreign grants, and the rest 0.2% from principal repayment. This leaves with a gross budget deficit of Nrs120.8 billion. Now, this is to be financed by a combination of foreign loans, domestic borrowing and FY2014 savings in the ratio 41:43.7:15.3.

FY2015 budget overview
GDP growth target (%)	6
Inflation target (%)	8
Budget allocation for FY2015	FY2015BE
	Rs billion	%
Budget allocation	618.1	100
Recurrent	399.0	64.5
Capital	116.8	18.9
Financial provision	102.4	16.6
Projected total revenue	497.3	100
Revenue	422.9	85.0
Foreign grants	73.4	14.8
Principal repayment	1.0	0.2
Projected budget surplus (+)/deficit (-)	-120.8
Projected deficit financing	120.8	100
Foreign loans	49.5	41.0
Domestic borrowing	52.8	43.7
FY2014 savings	18.5	15.3

On the composition of expenditure, revenue and deficit financing, two issues merit attention:

First, FY2014’s expenditure absorption rate was lower than FY2013’s despite the full budget. Okay, election related assignments slowed down expenditure related activities, but this doesn’t fully justify the lower absorption rate during better times. It indicates bureaucratic and government slackness and complacency— not good for a developing country with tremendous infrastructure investment needs.

About 89.6% of planned recurrent expenditure was spent in FY2014. Worse, about 75.1% of planned capital expenditure (lower than 82.6% in FY2013) was spent in FY2014. Hence, without much changes in the existing budget approval and execution setups, it is hard to believe that all of the planned capital expenditure will be spent in FY2015. And, the promised reform measures and amendment to Acts will take time (i) to complete the web of processes required to be before it reaches for debate in the CA, and (ii) after that implementation would also take time as policy and institutional arrangements are need for execution. So, it will set the stage for coming years, but potentially not impact this year’s expenditure figures.

Second, the most important thing that is missing in the FY2015 budget discussion is the accounting aspect. The government is using FY2014 fiscal savings equivalent to NRs18.5 billion to finance a part of the deficit, as mentioned in the budget speech. But then in the annex, this portion is included in the revenue heading (see the screenshot above). In FY2014’s budget, this was not the case even if there was a budget surplus in FY2013.

Now, as far as I understand, it is a bad practice to include last year’s fiscal savings as this year’s revenue. Ideally, this kind of savings should go to a trust fund to finance big infrastructure projects that face financing gap, and should be handled separately and independently. Or it could go to clear outstanding debt if debt burden is high, which for now is not the case as total public debt is just about 30% of GDP.

Treating such fiscal savings as revenue lowers deficit figures even when the government has to finance ballooning expenditure that are not met by usual trend of revenue growth. Note that lower deficit is a common yardstick for fiscal stability. Playing with numbers without much public clarity on the processes in order to show good fiscal standing may not be a standard practice.

Most of the expenditure items in FY2015 are recurrent in nature (even shoddy capital expenditure this year drains out a lot of money next year as more money has to be put in for asset maintenance—eventually becomes recurrent expenditure). If there are no fiscal savings this year then there will be pressures to bear more deficits in FY2016 (unless expenditure growth slows down along with higher growth rate of revenue mobilization—both unlikely as things stand right now).

Furthermore, the higher public expenditure threshold each year elevates inflationary expectation even if the actual expenditure is lower than planned expenditure at the end of the year. Higher inflationary expectations are already embedded in people’s consumption behavior, and household financial decision-making. Hence, the sticky prices at high levels for the last few years.

The baseline is that by treating last year’s savings as revenue this year, I think, a potentially bad fiscal accounting precedent is being set. Last year’s revenue mobilization were governed by last year’s finance bill, and this year’s revenue mobilization will be guided by this year’s finance bill, unless the latter explicitly specifies FY2014 savings as FY2015 revenue. Even this this is not a good practice. It creates issues with net fiscal deficit and net borrowing computations as well. These savings should not be used to finance uncontrollable recurrent expenditures. Correct me if I am wrong.

That said, there are a lot of good stuff in the budget. No point listing them all here in short blog post. Read them all here. For more specifics on expenditure headings, see this.

Twin troubles in Nepal’s tourism sector

Here is an article, written by Deepak Adhikari, about the troubles faced by the travel and tourism sector following the deadly avalanche on Everest’s Khumbu Icefall and the closing down of casinos.

Excerpts from the article:

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[…]The unprecedented halt to climbing on Everest, the world's highest mountain, has dealt a serious blow to Nepal's tourism industry, still recovering from a decade-long Maoist insurgency which ended only in 2006. But the mountaineering dispute is not the only area of conflict in the country's troubled travel and tourism sector.

Hopes of a casino-led gambling boom have faded as all 10 of the country's casinos have either shut for lack of business or closed their doors in a row over government regulations. The national tourism board has only recently reopened after months of conflict with private businesses alleging official corruption and incompetence.

[…]According to the tourism ministry's mountaineering industry division, 300 climbers from 32 expedition teams were at the Everest base camp when the avalanche struck. They promptly left the country. Another 500 had received permits to climb Everest and nearby mountains Lhotse and Nuptse in the spring season. These cancelled their Nepal visits outright.

[…]Chandan Sapkota, a Kathmandu-based economist, said the Everest problems could even force some Nepalis to emigrate. "The slowdown in this sector affects government revenue, foreign exchange earnings, seasonal employment, hotel and restaurant businesses in key tourist hubs around the country, trekking activities, and the aviation sector," he said. "If the slowdown persists, then in the absence of alternative employment opportunities, low-skilled workers might be forced to seek employment abroad."

Travel and tourism contributed more than 8% to Nepal's gross domestic product in 2013, according to the World Travel and Tourism Council, based in London. By some estimates, more than a million Nepalis are directly or indirectly employed by the travel and tourism sectors.

[…]Alongside the problems in the mountaineering industry, however, Nepal is also facing a crisis in its 40-year-old gaming industry. Seven of the 10 casinos shut in April after the operators failed to comply with new regulations introduced in 2013. Three closed last year -- two because of the revised rules and one after a labor dispute.

The new rules require casinos to have paid-up capital of at least $2.5 million, with a minimum of $1.5 million for the country's 17 slot parlors, known as mini-casinos, which are located along the porous Indian border. All of these also shut their doors because of the new regulations. There is also a new annual license fee, paid to the tourism ministry, set at about $207,000 for casinos and just over $100,000 for mini-casinos.

[…]Bhatta said the overstaffing was worsened by further hiring forced by the Maoists, who in the case of one casino forced it to hire 200-300 people from 2008 to 2009. The Maoists' demands "proved damaging to an already overstaffed operation," Bhatta said, estimating the excess labor force at about 40%.

[…]Officials say that about 11,000 casino employees have lost their jobs. But there is also a serious impact on the wider tourism industry. The casinos drew an estimated 150,000 tourists a year, filling about 15% of rooms in five-star hotels in Kathmandu. Occupancy levels are down by about 10%, according to analysts.

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Macroeconomic performance of Indian economy in FY2014

This blog post discusses FY2014 macroeconomic performance of the Indian economy. For macroeconomic update on Nepalese economy, see this and this.

Real sector (growth rate of real GDP, factor cost 2004-05 prices): The Indian government has projected the economy to grow by4.7% in FY2014 (ends 31 March 2014), marginally higher than 4.5% in FY2013 and reflecting the hard reforms needed to weed out the structural constraints constraining particularly agricultural and industrial sector. This below 5% growth rate for successive two years is the first time in the last 25 years. Agriculture sector growth of 4.7% is mostly due to the favorable monsoon rains, which increased agriculture production.

Industrial sector remains the vital to the recovery of the Indian economy as it: (i) accounts for 24.3% of total employment; (ii) it contributes about 21.4% and 45.1% of total inputs requirement in agriculture and services sector; and (iii) it accounts for 59.6% of total inputs employed in the economy. Rejuvenating growth in manufacturing is vital as it remains the core of intra and inter sectoral backward and forward linkages.

In expectation of a better manufacturing performance, the government is forecasting FY2015 GDP growth between 5.4% and 5.9% in FY2015 (expectation that growth will remain on the lower side).

Fiscal sector: Gross fiscal deficit is forecast at 4.5% of GDP, slightly down from 4.9% of GDP in FY2013. Revenue deficit is forecast at 1.2% of GDP and primary deficit at 1.2% of GDP in FY2014. The fiscal consolidation is largely a result of reduction in public expenditure. Further fiscal consolidation is required especially on two fronts: (i) raising tax-GDP ratio; and (ii) rationalization of subsidy regime.

Monetary sector: The Indian government is expecting inflation to moderate somewhat in FY2014, but it states that this rate is still above the comfort zone. Average headline WPI and CPI (IW) are forecast at 6.0% and 9.7% respectively (marginally down from 7.4% and 10.4%, respectively in FY2013), thanks to elevated food price pressures. There was a general credit slowdown with commercial bank credit growth of 13.9%, lower than a rate of 14.1% in FY2013.

In FY2015, inflationary pressures could come from two fronts: (i) lower agriculture production due to sub-normal monsoon; and (ii) higher prices of oil as a result of volatile geo-political situation in the Middle East.

External sector: As a share of GDP, current account balance is forecast at 1.7% deficit, substantially down from a deficit of 4.7% of GDP in FY2013. The average exchange rate stood at IRs 60.5 = $1, a depreciation from IRs 54.41 = $1 in FY2013. Foreign exchange reserves stood at $304.2 billion. As the rupee weakened, export recovered by registering 4.1% growth rate, much higher than a negative 1.8% growth in FY2013. Meanwhile, import decreased by 8.3% in FY2014, attributed to the measures taken by the government and RBI to discourage import of non-essential items, particularly gold.

Global growth drivers and policy challenges for the next 50 years

A latest OECD Economics Department policy note argues that growth in the next few decades will slow down and most of the growth will come from developing and emerging economies. The main drivers of growth will be innovation, skills and knowledge-based assets as population growth will continue to decline. 

Excerpts:

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While growth will be more sustained in emerging economies than in advanced economies, it will still slow down due to less population growth and less scope for catching up to the standards of living of the most advanced countries (Figure 1). Even if the retirement age is increased, population ageing will result in a declining or at best a stable labour force in most economies. Against this backdrop, future gains in GDP per capita will become more dependent on accumulation of skills and, especially, gains in productivity driven by innovation and the accumulation of knowledge-based assets -- such as organisational know-how, databases, design and various forms of intellectual property (OECD, 2013).

Global exports will continue to outpace GDP growth over the next half century with an increasing role of non-OECD economies in the global market. Exports in relation to GDP will on average rise by 60% between 2010 and 2060, and relatively closed (and large) economies as the United States and Japan will in 2060 be as open as the United Kingdom is today. As a result trade integration will keep rising, though at a slower pace than in recent decades.

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The major policy challenges identified in the report are:

• Dynamism in labor and product markets, and re-designed IPR policies
• Shift from mobile tax bases (labor and corporate income) to immobile ones (consumption, housing and use of natural resources)
• Public investment on pre-tertiary education and life-long learning
• International cooperation in providing global public goods (basic research, IPR, competition policy, climate change)