2012

Mineral & Energy Topics 598A John Paolillo

TAXTION OF GOLD IN INDIA

WSJ Article and Purpose of Analysis In an attempt to better understand the role gold plays in the Indian economy and consequently the effect gold demand in India has on the world price of gold, I analyze news and statistics related to those markets and, more specifically, recent taxes levied on gold. In an April 6th, 2012 article entitled India Jewelers End Strike Over Gold, in the Wall Street Journal (WSJ), it was reported [t]he strike has crippled Indias gold industry. Imports into the country, the worlds top consumer of gold, have all but ground to a halt. That has put a dampener on gold price globally (Rajesh & Mukherji, 2012). The cause of the three week long strike by Indian jewelers was an increase in the taxation of gold imported and sold in the country. As it stands, even after the strike ended, there is a 4% import tax on gold, a 3% excise tax on refined gold and a 1% excise tax on unbranded jewelry, up from 2%, 1.5% and 0%, respectively. The previous tax rates only went into effect in January 2012 with the increase that led to the strike occurring in mid-March. The WSJ article goes on to say that Mr. Bachhraj Bamalwa, chairman of the All India Gems and Jewelry Trade Federation (a group which distributes protest materials against the excise taxation of jewelry sales), claimed the strike cost Indias gold industry 200 billion rupees ($3.91 billion). The article also implies news of the tax caused the price of gold traded in New York to fall 1%, as traders worried the taxes would choke off Indias purchases of the metal. In the subsequent analysis, I purpose that the effect of the excise tax (but not the import tax) probably does weigh heavily on the jewelers, but is probably not the cause of demand for gold decreasing in India over the longer term. Rather, the reduced demand for gold in India is a symptom of a weakening global economy and persistently high inflation combined with the Rupees depreciation. Furthermore, I propose that demand for gold is relatively more income elastic than it is price elastic so reduction in both the actual and effective incomes of Indias citizens is the root cause of the decline. Gold Demand in India According the World Gold Council, India imported a record 969 metric tons of gold in 2011, up from 958 tons the year before (World Gold Council, 2012). Being that the world demand for gold in 2011 was 4067.1 tons, Indias importation made up approximately 23.8% of world demand. Obviously, by comprising such a large share of the world demand for gold, any changes in the quantity demanded for gold bullion in India will inevitably affect the world price of gold. By some estimates, demand for gold in India is likely to drop 7% in 2012 (Pearson & Afonso, 2012). Using a simple diagrammatic example of the following page, I show the demand shift in India and the presumed ability for that shift to affect world price of gold.
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Price

India Gold Market

Price

World Gold Market

2011 2012

2012
2011 2012

2011

Quantity

Quantity

From this very simple model, we can see that any decrease in demand for gold by India, because of its proportion of world gold demand, could very well cause a reduction in the world price of gold. Ajay Mitra of the World Gold Council goes so far as to say, If India sneezes, the gold industry will catch a cold (60 Minutes, 2012). To further understand demand for gold in India, it is beneficial to look at the reasons Indias citizens purchase gold. In 2011, it is estimated that over 60% of the gold purchased in India was in jewelry form, which is seen as a form of financial security and societal standing and is long engrained in the Indian culture (Parija & Mishra, 2012). No gold, no wedding, is a common phrase in India where an estimated 10 million weddings occur each year, 75% of which are reported to be arranged (60 Minutes, 2012). The other nearly 40% of demand for gold in India is actually in bar form and is traditionally used as an investment, although it is sometimes given in bar form in weddings also so that the bride is seen to have financial stability even without her new husband. The relationship between marriage and gold demand in India is strong enough that some try to predict the demand for gold in India based on the number of marriages in the country (Bhattacharya, 2002). Unfortunately, causality is not certain and this data is not considered to be very accurate and so is not examined further here. Income in India According the World Gold Council, imports of gold into India fell 44% in the fourth quarter compared to the same quarter a year earlier, with jewelry demand falling 44% and investment demand falling 38% (World Gold Council, 2012). Although this report is somewhat misrepresentative because,
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in India the largely Hindu population celebrates holidays which do not follow the calendar year by buying gold, it does give us a sense of how India responds to changes in the economy in terms of the level of gold they purchase. According to the World Bank, GNI per capita in India was $1270 (current US dollars) in 2010, increasing from years previous (World Bank, 2011). Unfortunately, there are not reliable estimates from more recently but, if we look at recent data on exports from India, the inflation rate and the percentage change in GDP, we can see that there are fewer goods flowing out of India, less money flowing into India and the prices of goods are becoming relatively more expensive for citizens. Below, we see that in the months from January 2012 to April 2012 that inflation in India (below) has increased from 7.5% annual change in CPI to 9.47% (Ministry of Statistics and Programme Implementation, 2012). The years of stubbornly high inflation have continued to erode the purchasing power of Indian citizens who also see gold as a safe haven against the weakening Indian Rupee.

India Inflation Rate

Annual Change on Consumer Price Index

The high inflation rate combined with a recent decrease in exports (below), has led to dramatic increase in the current account deficit of India (bottom of the following page) and led to the Minister of Finance, Pranab Mukherjee releasing a budget, which included the tax on gold (Mukherjee, 2012).

India Exports
Exports by Month (Million USD)

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Spot Gold Price -vs- India Gold Investment Demand

Prices per Ounce (USD, INR) Quantity in Tonnes

Source: Thomson Reuters GFMS, World Gold Council

India GDP Annual Growth Rate

Percent Change in Gross Domestic Product

Source: Ministry of Statistics and Programme Implementation

India Current Account

Current Account (Billion USD)

Source: Reserve Bank of India

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The Reason for the Tax on Gold As gold is the second most imported good in India (behind oil, where the purchase is in fact subsidized at a cost of approximately 2.5% of GDP (Reuters, 2012)), the government of India is claiming that the tax on gold will induce Indian citizens who save over 30% of GDP (below), often in gold form, to find other places to invest.

Gross Savings in India

Percentage of Gross Domestic Product

Source: www.tradingeconomics.com

The hope is that the private investment will go towards infrastructure, of which approximately 70% is already due to private investment, largely in the form of telecommunications (World Bank, 2011). With elections in 2014, there is some speculation that the government is using only slightly abrasive tactics now, in an attempt to reduce the current account deficit, and increase private investment in infrastructure (since the government budget wont allow it) because in the years to come they will need to offer populist subsidies to induce votes (Reuters, 2012). Interestingly, there is some evidence that the best thing that could happen to India in terms of creating financial stability is a correction (drop) in the world price of gold, which may come with a reduction in demand and increased taxes (Mishra & Mohan, 2012). Ultimately though, it appears that the global economic slowdown (which has recently unnerved potential customers of Indias exports) combined with a government bound to subsidize other imports is largely to blame for the current account deficit, not necessarily gold importation. The Effect of the Tax on Gold When we look at the effect of the price of gold in India relative to investment demand for gold (top of previous page) we do not see as strong of a link as we do with investment demand and percent change in GDP (middle of previous page), where there appears to possibly be a lag in investment demand which is correlated to the previous change in GDP. I believe that this is evidence of a relatively elastic income elasticity of demand for gold in India as compared to the price elasticity of demand for gold although both are estimated to be greater than 1 (meaning a 1% change in income or price leads to
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a greater than 1% change in gold demand) (Bhattacharya, 2002). During the Akshaya Tritiya festival, when it is believed to bring good luck all year to buy gold, total demand was down an estimated 4050%, with Indians buying lighter weight gold jewelry (Nayak & Mukherji, 2012). Below, using another simple model, I try to explain the tax incidence on investors/consumers and jewelers. To reduce complexity here, I assume that the supply curve in Indias jewelry market is linear and more specifically is unit elastic at the current price. Simply stated this just means that for a 1% change in the price of gold jewelry there will be a 1% change in the quantity supplied by the jewelers. As a matter of housekeeping, it should be noted that the initial price in the Indian jewelry market, , which carried over from

the Indian gold import market would also include the relevant increase in price associated with the craftsmanship of raw gold into fine jewelry.

Price

India Gold Import Market

Price
Reduction in CS from Import tax DWL

India Jewelry Market

Reduction in CS From Excise tax

DWL

Quantity

Reduction in PS From Excise tax

Quantity

We can see from the gold import model above (left) that the price of gold after the import tax would be passed on to those buying imported gold for investment purposes, and also (assumedly) to the customers of gold jewelry (right). It should be noted that jewelers would have shifted supply inward (not shown here explicitly) as the input price of gold increased with the import tax but, the decrease in their surplus is embedded in the loss in surplus and/or deadweight loss shown in the gold import demand model. In the jewelry market, the excise tax levied is partially passed on to the jewelry customers but, because of the assumed relative elasticities, is primarily the burden of the jewelers. Finally, in considering the benefit to the government in the form of tax revenue (which is the sum of the areas labeled as a reduction in either consumer surplus or producer surplus on both graphs), we must
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recognize the deadweight loss (DWL) which is created by the new policies and represents inefficiency which has been introduced into both markets by the distortionary taxation of raw gold imports and refined jewelry sales. Conclusions In India, gold acts as a hedge not only against the rapidly appreciating Indian Rupee, but also against the near double digit inflation in the country which has persisted for years. Additionally, and perhaps more significantly, ownership of gold is seen as an achievement of which a person is incomplete without. These factors, and a large population, have driven India to become the number one consumer of gold in the world. As the world economy has slowed down and again demanded fewer Indian exports, the government of India faces a current account deficit which is at least in part also due to the subsidy of various imported goods, most notably of which is oil. Because gold is the second most imported good in India, the government sees it as an easy target to not only increase tax revenue (which later perhaps it can use to persuade voters) but also to ease political pressure created by their growing current account deficit. Regrettably, the policy does little to address the decrease in the nominal and real incomes of Indians and in fact makes the matter worse, especially considering the apparent utility which is gained from its purchase and ownership. The jewelers who so adamantly oppose the excise tax, which is to be reconsidered later in the year, seem unconcerned that even after the strike ended the government vowed not to remove the import tax (Rajesh & Mukherji, 2012). As I have shown, this is most likely because the jewelers can pass much of the cost of the import tax on to their customers but not the majority of the cost of the excise taxes. Unfortunately for Indian consumers of gold, the current state of the world economy, combined with high inflation and a depreciating Rupee is the leading cause of their reduced surplus and it appears to only be worsened by taxation policy introduced by the Indian government.

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References
60 Minutes. (2012). India's Love Affair with Gold. Bhattacharya, H. (2002). Deregulation of Gold in India. London: World Gold Council. Ministry of Statistics and Programme Implementation. (2012). India Inflation Rate. Retrieved May 2, 2012, from www.tradingeconomics.com: http://www.tradingeconomics.com/india/inflation-cpi Mishra, R., & Mohan, G. (2012). Gold Prices and Financial Stability in India. Department of Economic and Policy Research, Reserve Bank of India. Mukherjee, P. (2012, March 16). Budget 2012-13. Ministry of Finance, Government of India. Nayak, D., & Mukherji, B. (2012, April 25). India Demand for Gold ETFs Rises on Festival. Wall Street Journal. Parija, P., & Mishra, P. (2012, March 16). India Raises Gold-Import Tax for Second Time; Prices Drop. Retrieved May 2, 2012, from www.bloomberg.com: http://www.bloomberg.com/news/2012-03-16/indiaraises-gold-import-tax-for-second-time-prices-drop-1-.html Pearson, M., & Afonso, S. (2012, February 21). Gold Imports by India Seen Dropping From Record to Make China Top Consumer. Retrieved May 2, 2012, from www.bloomberg.com: http://www.bloomberg.com/news/2012-02-20/gold-imports-by-india-seen-declining-from-record-onhigh-prices.html Rajesh, R., & Mukherji, B. (2012, April 6). India Jewelers End Strike Over Gold. Wall Street Journal. Reuters. (2012, March 16). India's Troubled Government Delivers Cautious Budget. Retrieved May 2, 2012, from www.cnbc.com: http://www.cnbc.com/id/46756264/ Trading Economics. (2012). Gross Savings (% of GDP) in India. Retrieved 5 2, 2012, from www.tradingeconomics.com: http://www.tradingeconomics.com/india/gross-savings-percent-of-gdp-wbdata.html World Bank. (2011). India: World Development Indicators. Retrieved May 2, 2012, from data.worldbank.org: http://data.worldbank.org/country/india World Gold Council. (2012). Gold Demand Trends. London: World Gold Council.

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