The GDP growth rate is determined by two factors: the investment rate and the efficiency in the use of capital. The Harrod-Domar equation defines the relationship: the growth rate is equal to the investment rate divided by the incremental capital-output ratio (ICOR).

The ICOR measures the capital required to produce one unit of output. The higher the ICOR, the less efficient the economy is in the use of capital. Lower the ICOR, higher is the productivity of capital.

The investment rate is the share of the gross fixed capital formation (measure for fresh investments in the form of plant and machinery, dwellings and other buildings) in the GDP.

In the last five years, India’s investment rate has declined and the ICOR has risen. In such a scenario, GDP growth rate was bound to slow down.

India’s investment rate peaked in 2007-08 at 38.0 per cent of GDP. At that time, the ICOR was 4, and the GDP growth rate was more than 8.5 per cent. During the high-growth phase from 2004-2005 and 2007-2008, the ICOR was 3.4. Between 2014-2015 and 2017-2018, the ICOR averaged 4.3. It was 5.5 between 2011-2012 and 2013-2014, when the economy went through a growth slowdown and a policy paralysis.

The investment rate averaged 31 per cent from 2014-2015 to 2017-2018. It was 33.6 per cent in 2009-2010 and 2013-2014. It touched a ten year-low of 30.3 per cent in 2015-2016.

With the investment rate of under 30 per cent (it was 29.7 per cent in 2017-18), GDP growth rates of above 8 per cent cannot be achieved.

Data from the Central Statistics Office (CSO) and the Reserve Bank of India (RBI) shows that the main reason for the decline in investments is a slowdown in private corporate sector investments and household investments. RBI data shows capital expenditure by the private sector declined for the sixth straight year in 2016-2017.

Private corporate investments have slowed down because of capacity overhang, and because companies are deleveraging and restructuring their balance sheets and are applying themselves to improving their capital structure. Debt/equity and interest coverage ratios are improving even as investments remain dormant.

RBI data suggests overall capacity utilisation declined to 74 per cent at the end of December 2017 from 81 per cent at the end of March 2011. But it reached a six-year high of 77 per cent at the end of March 2019.

CRISIL Research shows capacity utilisation in some large industrial sectors, such as thermal power, two-wheelers, tractors, cars, cement and steel, remains below the peak. Capacity utilisation levels increased in power distribution, mobile tower capacity and auto ancillary sectors. Capacity utilsation levels improved only in select sectors, but large manufacturing units are still operating at lower-than-full capacity. Improving the capacity utilisation is a pre-condition for reviving private investments.

If India has to attain a size of $10 trillion in a short period of time, the potential growth will have to be raised to above 8.5 per cent.

The key policy challenge then is: How can the GDP growth rate be pushed when the investments rate is not responding to policy measures, including monetary and fiscal loosening?

Growth has not yet responded to cumulative repo rate cuts of 110 basis points in 2019 till August. The scope for increasing centre’s capital expenditure was estimated at merely 1.6 per cent of GDP in the 2019-20 budget. This gets only a small boost from the largesse of Rs 1.7 lakh crore received from the RBI in form of surplus and dividends because much of the transfer was factored in already in the budget’s estimates.

Further, the infrastructure sector is in a slump. The National Highway Authority of India’s (NHAI) debt has shot up from Rs 40,000 crore in 2014 to Rs 1.78 lakh crore in 2019.

The government must lay out the goal of improving the ICOR to 4 and then to 3.

The Economics of ICOR

• In the immediate term, a project monitoring group must be constituted in the Prime Minister’s Office with full powers to co-ordinate with state governments. This team must first identify the viable projects from the stalled ones. And, then resolve the bottlenecks needed to bring them to completion. In the April-June 2019 quarter, implementation of investment projects worth Rs 13 trillion were marked stalled—the highest value since CMIE began compiling data in 1995¹.
• Second, the financial and banking systems remain under stress. The Modi government has taken some measures to improve liquidity and resolution of the non-performing assets. This includes the Bankruptcy Code. But the squeezed profitability of banks is not improving quickly enough still and the flow of new credit remains sluggish. The decision to merge public sector banks to create larger ones is a good step but the process will take time. 
• The Modi government has taken some measures to improve liquidity and resolution of the non-performing. This includes the Bankruptcy Code. But the squeezed profitability of banks is not improving quickly enough still, and the flow of new credit remains sluggish. The decision to merge public sector banks to create larger ones is a good step but the process will take time.Already, the insolvency risk has increased in the corporate sector because of the stock market correction underway.
• About 195 non-financial, non-government-owned companies owe Rs 13 trillion to various lenders². This is the highest in the last five years and up 47.5 per cent from a low of Rs 8.8 trillion in March 2018 and Rs 11 trillion in March 2019. Borrowings by these companies now exceeds their market cap. In all, 54.5 per cent of all corporate loans in the listed space (ex-financials and ex-government companies) are now with companies with inadequate market cap. Low valuations are choking finances in capital-intensive sectors such as telecom, power, metals, mining, infrastructure, starting a vicious cycle of low liquidity, poor profitability and even poor market cap.
• Against this backdrop, a medium-term strategy to use policy push for select high-value sectors in a focused way such that the ICOR improves is the most appropriate for reversing the slowdown and reaching the target of $10 trillion.
• ICOR can be improved by capturing the high-value generating segments in global business. Consider these examples: Airbus and Boeing make greater profits than all airlines of the world put together. Pfizer makes more profits than the world’s top 100 hospitals put together. Cisco makes more profits than the top five telecom service providers in Europe. Apple and Google will soon be dominating the auto industry with their driver-less cars. Where is India in all of this, although there are many Indians in these success stories.
• The first imperative of such a strategy would be to recognise that scientific research plays a role in industrial innovation and incentivise investments in Research & Development (R&D). India’s investment in R&D has stagnated over the last 30 years, ranging between 0.6 per cent to 0.9 per cent of GDP3. The share of industry in total R&D in India is the lowest of any major economy, while that of public funded R&D is the highest.
• R&D is crucial to creating high value. The top ten companies in China invest 8 per cent of their turnover in R&D. The top ten companies in India, in comparison, invest only 1 per cent of turnover in R&D.

• Of the top 2,500 R&D spending firms worldwide, accounting for over three-fourth of global industrial R&D spending, only 26 are Indian firms against 301 Chinese and 80 South Korean. Of these 26, 19 are in just three sectors: pharmaceuticals, automobiles and software. India does not have a single firm in the top five R&D intensive firms of the world⁵.

This explains why ICOR is weak but also how it can be improved. The following policy corrections are recommended:

• Until 1990s, import of technology into India was restricted. But it no longer is. There’s need to set tone for discourse on technology and foster a research culture.
• India has a comparative advantage in the key input for this strategy, the affordable supply of super-specialised skills, that needs to be harnessed. Combining commercially valuable research with teaching, as is practised in IIT Powai for instance, is the best model and needs to be replicated across the system. Industry-academia partnerships will increase availability of trained researchers, it will integrate curriculum with industrial use and commercial value. For this, faculty vacancies must be immediately filled up and a system of collaborations between industry and researchers needs to be designed. A network of Chief R&D Officers, as high up in the pecking order as the CEO and CFO, across the corporate sector with links in academic campuses and laboratories needs to be formed.
• High-potential industry segments need to be identified and National Innovation System Hubs focused on key sectors should be set up in collaboration with the premier research institutes.
• While firm strategy and promoting entrepreneurship are important, high-value focus needs a mindset change, a paradigm shift where profits are based on value creation and excellence, not labour cost arbitrage. The strategy will succeed only if the trade policy is not protectionist but promotes competitiveness.
• This is a capital intensive strategy with relatively less potential for jobs-creation. But it’s a must to reverse the brain-drain from our premier educational institutes and pave the way for exports-led growth.
• Startups are still being asked by income tax assessing officers to pay the tax, despite producing exemption certificates issued by the department of industrial policy and promotion. Cases have been recorded where Startups were forced to shut down after investors backed out over angel tax.For the jobs-generative part of the economy, a separate strategy needs to be put in place. In my travel to Ahmedabad, I came across small and medium enterprises (SMEs) using the best of technology with great potential to grow into large successful companies that can be world beaters one day. But policies – from those governing land, labour, infrastructure, taxation, regulatory clearances – either kill or stunt them.
• Because of problematic policies hold back good efficient firms become like aquariums, that can’t grow into big massive oceans. For generating jobs and incomes, or purchasing power, at the scale required, companies need to be able to grow. To increase efficiency, a second round of 1991-type reforms is needed. This calls for greater political will since an omelette can’t be made without breaking eggs. Reforms to simplify procedures, speed up the delivery system and enlarge competition need to be top priority. 
• India is a powerhouse of entrepreneurial talent. Yet, Indian companies are not competitive in large part because of the stunting policies that have been in place for decades. The government just needs to get out of the way and let these companies and the entrepreneurial spirit take wings. With them the economy will just take off.
• The government has been taking the easy way out by raising import tariff walls to protect uncompetitive industry against imports. Take the example of the auto sector, as pointed out by Arvind Panagariya: Today, custom duty is 60 per cent on cars costing less than $40,000, 100 per cent on more expensive cars and 125 per cent on used cars⁶. High tariff protection has allowed inefficient small auto plants to thrive in India at the cost of the consumer. In many cases, consumers are paying one and a half times the price that the consumers elsewhere in the world pays for the same car. This is why the economy is a high-cost, inefficient and uncompetitive one.
• The GST system’s long-term benefits include better transparency, higher revenue generation, a wider tax base, collection efficiency, formalisation of the economy and limiting tax evasion/corruption.
• To realise those, the glitches in the GST’s collection systems and rates structure need to be ironed out urgently. Simplifying the direct taxation structure ought to be the top priority. The present Income Tax Act was passed in 1961, more than 50-years ago. It is no longer commensurate with the structure or the needs of the contemporary economy. Amended more than 2,000 times, the Income Tax Act, 1961 is incomprehensible and, in many places, even contradictory. Increasingly, the clear position of law is no longer discernible to taxpayers, tax administrators, practitioners or judges. This leads to avoidable waste of national time and economic resources, and growing scope for rent-seeking by the taxman.
• The threat of the ‘angel tax’ – the income tax on capital raised by unlisted companies via issue of shares, where the sale price is seen in excess of the fair market value of the stock sold – is yet to recede despite assurances from the government that Startups won’t face harassment on this count. Instances have been reported where Startups are still being asked by income tax assessing officers to pay the tax, despite producing exemption certificates issued by the department of industrial policy and promotion⁷. Cases have been recorded where Startups were forced to shut down after investors backed out over angel tax.

Banking and Financial Sector Needs Attention

• Despite the improvement in the ease of doing business rankings in the World Bank’s surveys, the operating environment remains difficult with a number of documentation/clearances required. 
• The legal framework needs to be simplified, clogged courts and judicial pendency needs to be improved. 
• Any progress on these reforms will ensure that in return for a strong consumption-driven market, foreign investments will provide part of the funding gap for infrastructure projects and provide technological know-how to expand the domestic manufacturing base.
• There is tremendous scope for increasing the flow of foreign investments. In 2007-08, foreign investment as a proportion of GDP was around 5 per cent. Today, it is greater in absolute numbers but, as a percentage of GDP, it is less than 2.5 per cent⁸. 
• India has one major advantage over the advanced and many Asian emerging market economies—the potential for demographic dividend. The growth in its working age population is not peaking. Rather, India’s working age population will exceed overall population growth for at least two more decades, leading to sustained fall in its dependency ratio. According to the UN, India’s working age population will rise from 66 per cent to 68 per cent of its total population in the time period from 2015 to 2040. 
• India will overtake China, whose share of working age population will fall from 73 per cent to 62 per cent over the same 25-year period. 
• To harvest this demographic dividend, jobs will have to be created. Jobs that will gainfully absorb the working age population and give them with purchasing power. Nearly 90 per cent of the labour force is presently in the unorganised sector. Unless this changes neither will purchasing power, nor will companies’ size grow. Hence labour issues need to be addressed to be able to reach the goal of $10 trillion. 
• Policy imperatives for this are that growth has to be inclusive and generate productive employment; the employment elasticity of growth has to progressively increase; the workforce needs to be skilled and made employable; and casual and informal labour needs to be absorbed into the organised sector employment. 
• These goals break down into steps ensuring increased use of technology and digitalisation across sectors including banking services, healthcare and education. Focus on widening the manufacturing base to absorb the slack from the farms. Formalising the economy and encouraging the scaling-up of manufacturing activity and organised sector employment. Addressing corruption/lower tax evasion by simplifying the tax system. 
• The major constraint here is the capacity of bureaucrats and officials in the government to give up controls and allow good decision-making. The experience of the GST showed how the best of political intentions where politicians are willing to take risk run up against the speed breaker of bureaucratic incompetence and in some places even vested interests of bureaucrats. 

A policy of seeking mandatory data localisation by companies based abroad must be speeded up. The data localisation rules should make it mandatory for foreign companies to store personal data of their users and customers in India within the Indian territory. Just like the RBI’s new norms for localisation of all sensitive data belonging to Indian users of various digital payment services to be complied by card payment services such as by Visa and Mastercard and also of companies such as Paytm, WhatsApp and Google, which offer electronic or digital payment services.

• The increase in costs—servers, the UPS, generators, cooling costs, building and personnel—is affordable and will not make much of a dent on profitability of global giants compelled to localise data.
• World over economies protect their data very carefully: Canada and Australia are well known examples for health data. Vietnam mandates storing locally copy of the data for any company that collects user data to have a local office. China too mandates strict data localisation in servers within its borders. 
• The other big opportunity lies in aggregators and technology-enabled e-Commerce. This sector has the potential of catapulting into the big league because the size of the Indian market is large, and, at the same time, the pool of suppliers of goods and services is also as large and varied. 
• E-Commerce aggregates existing products and services through an online platform to ensure better utilisation of these assets for their owners and widen their reach to new customers. The obvious categories of e-Commerce fashion, public transport and food delivery are already well-entrenched in the market. Other categories, such as grocery, home services and logistics, are finding their feet. But why can there not be an UrbanClap-like aggregator for say hiring services of filing of tax returns or tally-accounting by chartered accountants or healthcare and wellness services run by professional doctors and specialists? This will not only reduce the cost of doing business for the self-employed and micro-sized firms, it will also create new incomes for the large number of professionals in the country. 
• But for these ideas to take off, there will have to be strong resolve to iron out the policy problems that obstruct these ventures. Since failure rates are high, there is all the more reason to provide the enabling environment for Indians to try and try again to realise their entrepreneurial potential without getting frustrated.
• Five years after the Startup boom got kicked off, companies are struggling to grow in size. Competition from global giants has made it an unlevelled playing field. The business ecosystem in India is not as enabling. This needs to change. Here the simplification of GST and personal income tax system, the costs of warehousing, transporting and logistics, and other policy reforms are needed.
• The cost of starting a business remains high. The red-tape and procedures involved remain daunting even after huge improvements under Modi 1.0. There are 12 procedures to complete in the initial set up of a business costing 49.8 per cent of income per capita. It takes almost a month to complete the tasks on average, which is well above the OECD average of 12-days.