India must make net-zero goal competitive for small firms, not rely on major corporations

The Indian government must reform its model of state ownership of DISCOMs. A more market-driven approach will improve autonomy, and financial viability.

The Print
19 June 2024

Large parts of India are reeling under a heatwave, a clear manifestation of the broader climate crisis we are all facing. Measures to reduce our carbon footprint and strategies to mitigate and adapt to the impacts of climate change are needed.

India has made commitments to become net zero by 2070 and has set an ambitious target of producing 500GW from renewable sources. This requires massive investments in green technologies, infrastructure, and resilience-building measures. Since public funds won’t be enough, private capital is required at a large scale to meet these goals. India must address legal and regulatory frictions, project risks from policy uncertainty, and macroeconomic risks to ultimately reduce the cost of capital and enhance investments in the energy transition. This should be done in a way that accommodates both small and large firms, where the competitive space is not distorted in favour of big companies.

The cost of capital

Private investments are tied to the cost of capital—generally a weighted average of the interest rate that companies have to pay on debt, and the returns demanded by equity investors. In other words, it is the rate of return that investors require to make the investment worthwhile. The cost of capital is fundamentally driven by the perceived risks associated with the project. If the risk is high, investors will seek higher interest rates or greater returns to compensate for the increased uncertainty.

According to a report by the International Energy Agency (IEA), the nominal cost of capital in India is about 10 per cent, compared to around 4 per cent in Europe and the US, and 5 per cent in China. Another report published in 2020, by the IEA and the Centre for Energy Finance at the Council on Energy, Environment and Water (CEEW), also states that interest rates for 16-18 year loans for solar PV projects to be around 10-11 per cent. This increase is based on off-taker risk (the risk that distribution companies (DISCOMs) cannot pay generation companies in full or on time), the current policy, regulatory and market development. Financing costs account for almost 49 per cent of the overall costs of a solar PV plant in India, compared to about 25-31 per cent in the EU, US and China.

Reasons for high cost of capital

Private capital faces three major impediments in India. First is the risk stemming from policy and regulatory uncertainty, where changing laws and regulations can undermine the stability and predictability essential for investment. A report by BBVA Research suggests that specific risks of renewable projects prevail in India, such as regulatory, transmission network, and off-taker. These risks include laws and regulations that are susceptible to frequent changes, delays in the signing of Power Purchase Agreements (PPAs), the risk that the transmission network may not be able to evacuate power, and DISCOMs not making payments on time or sometimes reneging on contracts altogether. These are often known as the “micro risks”. The second barrier is “macroeconomic risk”, encompassing factors such as inflation, currency volatility, and economic instability, which can significantly impact returns on investment.

Transaction costs of doing business is the third impediment. Frictions created by legal and regulatory regimes can complicate or delay investments, and sometimes prohibit them altogether. An example of this is the market for blended finance. In a blended finance instrument, public or philanthropic capital assumes the base risk. This attracts private capital into areas or projects where it otherwise wouldn’t because of high risk or low profitability. Indian regulations make a clear distinction between for-profit and not-for-profit endeavours. This inhibits the mixing of commercial sources of funds with concessional ones, and thereby de-risking of investments.

Need for policy push

India has, so far, addressed some of these impediments on the “micro risks” by making specific interventions, but not solving the problem at a systemic level. As an example, the off-taker risk has been dealt with by administering solar and wind projects through the Solar Energy Corporation of India Limited (SECI), which maintains a payment security fund that provides greater certainty of timely payments from DISCOMs. Generators prefer signing PPAs with SECI, which in turn signs power sale agreements with DISCOMs. The Indian government has also made attempts at improving DISCOM performance through efforts such as the Revamped Distribution Sector Scheme and the Late Payment Surcharge (LPS) rules.

However, neither the arrangement with SECI, nor the schemes go to the heart of the problem, which is the State control of DISCOMs. Political interference in the setting of tariffs becomes easier, and regulatory independence becomes weaker when DISCOMs are State-owned. Reforming the current State-ownership model toward a more market-driven approach will improve autonomy, and financial viability. Finally, there is even less of an effort toward regulatory reform to solve the high transaction costs in India. This is particularly problematic because it generates a bias where large projects get through and smaller projects fall off the radar. The competitive landscape gets distorted in favour of big projects and big companies. This is not conducive to an economy-wide energy transition.

Top & bottom of the income pyramid pose different tax problems. New govt must choose reform

A government can afford to make tough decisions in its early days. Resisting populist concerns, we need long-term reform such as broadening the tax base and removing deductions.

The Print
5 June 2024

It’s in the early days of a government formation when tough decisions are usually made. Rationalising the structure of direct taxes is an issue where a new government can resist populist concerns and take steps that may yield long-term benefits. In FY23, the government raised almost Rs 7.1 lakh crore from individual income taxes, and it expects this figure to increase to Rs 10 lakh crore in FY25. These are some of the best numbers India has ever seen. And yet, tough decisions on broadening the tax base, removing deductions and exemptions for certain classes of professionals, and lowering incidence at the top of the income pyramid may truly lead to improvements in our tax-GDP ratio.

Taxes distort people’s behaviour

A fundamental rule of human behaviour is that we will avoid what we think is not in our interest. One area where this plays out is the payment of taxes. Those of us who have a salary don’t have much choice but to stare at our net earning after tax deduction at source (TDS) every month. But for everyone else, considerable time and effort is spent in figuring ways through which one’s tax outflow is minimised. Sometimes this is done through classifying transactions such that they fall into the least taxed bracket, showing expenses to square off other income, choosing to be a “consultant” instead of an “employee”, and sometimes just dealing in cash to avoid paying taxes altogether. While this may yield benefits to the individual in the form of a lower tax burden, it does not achieve the objective for which the system was set up—to collect the maximum taxes to finance public goods and welfare expenditures while causing the least burden from taxation to individuals.

The economics literature on taxation is old and established. There is little doubt by now regarding the following proposition. The higher the tax rate, the higher the distortion in people’s behaviour. An increase in the tax rate may make you consume less, work less, or spend resources in trying to avoid the tax. This is known as the “excess burden” imposed by the tax and is seen to rise with the square of the tax rate. This is also known as the “deadweight loss”, which is the added cost to taxpayers and society of raising revenue through taxes that distort economic decisions. Thus, an increase in the tax rate might increase revenue. However, it also increases the “excess burden”, potentially negating some of the revenue gains from the increased tax rate. The taxation structure that yields the best outcome is one where the tax base is broad: Everyone pays taxes, and the tax slabs, exemptions, and concessions are minimised. This allows for the lowering of taxes, thereby reducing evasion, and the time and effort spent in one’s tax management. Tax compliance is as much about the stick as the carrot. Enforcement has to be tough, but it works best when people are incentivised to obey the law.

The Indian experience

The Indian history of direct taxes bears out the futility of high tax rates. As a paper written by economist M Govinda Rao points out, the marginal tax rate on individuals with income above Rs 20 lakh was 97.5 per cent in the 1970s. At that point, less than one per cent of the population paid the tax; the revenue from individual income tax was just about 0.8 per cent of GDP. As the tax rate became rationalised, tax compliance got better.

While the marginal tax rate was down to 30 per cent by the mid-1990s, there were still some complications in the form of standard deductions and tax incentives for things such as financial savings in specific instruments or home loan payments, among others. These create their own set of distortions in the financial portfolios of households, with savings being channelled to insurance and the public provident fund, which may not always be the best decision from a risk-return perspective. More recently, the new tax regime has made a move towards lowering the tax rate by doing away with several deductions. However, this is still optional, and there are more tax brackets in the new regime, adding a different layer of complication.

There are two areas where the numbers are still disappointing. According to income tax data, there were about 6.4 crore individual taxpayers in FY22. Of these, about 4.3 lakh individuals filed returns with gross total income greater than Rs 50 lakh. Our intuition would suggest that there continues to be considerable tax evasion in India.

The second is the large number of people who do not fall into the tax bracket at all because those earning up to Rs 3 lakh a year pay no tax. As of FY22, between 80 lakh and one crore individuals with income less than Rs 3 lakh filed returns. As inflation rises, there is tax bracket creep, and more people eventually end up in the higher tax brackets.

This has been one reason to continue with the low tax base strategy in India. However, with inflation targeting in place, the tax bracket creep is going to be limited. This low tax base at the bottom of the income pyramid is as much of a problem as the low count of individuals at the top of the pyramid.

Where next?

Multiple committee reports have looked at the direct tax structure in India and recommended rationalisation strategies. These have been politically very difficult to implement. All the more reason why a new government should seize the opportunity for reform.