CHAPTER 2 CONTRIBUTIONS OF SERVICE SECTOR FOR INDIAN ECONOMY: AN OVERVIEW

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1 CHAPTER 2 CONTRIBUTIONS OF SERVICE SECTOR FOR INDIAN ECONOMY: AN OVERVIEW 2.1 Introduction Service sector has emerged as the dominant sector in the Indian economy, and its share in GDP at factor cost has risen from 33.3 percent in , to about 59 percent in (GOI 2013a). While agriculture and manufacturing sectors have experienced phases of deceleration, stagnation and growth, tertiary sector in India has exhibited a uniform growth trend since There is growing evidence of tertiarisation of production world-wide, as was first observed by Kuznets (1966). The present share of services in India s GDP compares with that of the top developed countries. While countries like the United Kingdom, United States and France have the highest share of services in GDP at about 78 percent, India s services share of 59 percent is much higher than other developing economies. Among the top 12 countries with highest overall GDP in 2010, India ranked 8 in terms of overall GDP, and 11 in terms of services GDP (GOI 2012). Service sector is expanding not only in terms of its share in the country s GDP, but also in terms of employment, international trade and FDI. The Indian economy exhibited considerable resilience during the recent global economic crisis, by maintaining one of the highest growth rates in the world. Service sector growth contributed in a big way to this resilience. Service sector accounted for around 88 percent of the growth rate in India s real gross domestic product in (Das, Banga, and Kumar 2011). External stabilisation is a crucial component of macroeconomic stabilisation for any country. Macroeconomic stabilisation usually involves returning to a low level of inflation, and a sustainable position with regard to fiscal and current account balances. However, our focus here is restricted to external stabilisation, which is being expressed in terms of current account balance as a percentage of GDP in this study. The advent of the global financial crisis in 2008 and the resulting economic recession has led to a sharp deterioration in India s current account deficit and balance of 28

2 payments in recent years. India s CAD as a ratio of GDP stood at 4.2 percent in The IMF s approach to external stabilisation, which often involves a reduction in CAD by introducing painful structural adjustment measures such as deep cuts in domestic investment, is not a good recipe for economic growth. The main focus of this chapter is to describe the economic contributions of service sector for India s growth and external stabilisation, from to , by contributions to GDP, investment, tax and employment. The contribution of services trade and other invisibles to India s external stabilisation is also analysed. Further, identifying the major service sub-sectors (traded and non-traded) in terms of economy-wide contributions can help in understanding to what extent service sector can act as an engine of economic growth and external stabilisation for the Indian economy, and arrive at policy implications. However, contributions of service sector to Indian economy are multi-dimensional and this chapter provides a background for the rest of the chapters which relate to services trade in particular. Rest of the chapter is organised as follows. Section 2.2 discusses the methodology for this analysis. Section 2.3 gives the empirical results. Section elaborates on the Services GDP contribution to India s economic growth. Section describes the Services investment contribution to India s economic growth. Section discusses the Service tax contribution to India s economic growth. Section elaborates on the Service sector contribution to employment generation and growth. Section throws light on the contribution of services trade and other invisibles towards India s external stabilisation. Section 2.4 provides the chapter summary in the form of a table. 2.2 Data and Methodology The time-span of this study is from to The framework for studying the Services GDP contribution to economic growth is as follows. The service sector contribution to India s economic growth is initially assessed, resorting to the methodology used by Jalava and Pohjola (2002). Next, the sectoral contribution to Services GDP is assessed by allocating total Services GDP across different subsectors. Similarly, Services GDP arising from public sector is also allocated across different sub-sectors. Contribution of private sector to India s Services GDP is obtained by netting out public Services GDP, from total Services GDP. Then GDP 29

3 arising from different privately-owned services is examined, to narrow down on the major contributors to growth. This analysis is carried out with the help of percentage shares and growth rates, utilising data published in National Account Statistics (NAS) of Central Statistical Organisation. Composition of public sector and private sector in India s National Account Statistics is explained in Appendix 4. The services investment contribution of economic growth is analysed by making a distinction between public and private investment, and further distinguishing private investment into domestic and foreign investment. Investment is usually measured in terms of Gross Capital Formation (GCF). GCF is defined in the System of National Accounts as the total value of Gross Fixed Capital formation (GFCF) and change in stocks. The NAS provides data on GCF at the sectoral and sub-sectoral level, for the aggregate economy and for public sector in particular. However, it is not possible to distinguish private investment into domestic and foreign investment in the NAS framework, due to non-availability of data. Therefore, Foreign Direct Investment (FDI) contribution of service sector is analysed separately utilising sectoral-level FDI data from the SIA newsletters, published by the Department of Industrial Policy and Promotion (DIPP), Ministry of Commerce. The contribution of service sector investment to India s economic growth is also analysed utilising the expenditure approach to national-income accounting and incremental capital-output ratios. Further, the growth-rate of service sector is predicted, using Harrod-Domar Model. This empirical analysis is done by computing the percentage shares, growth rates and investment rates. The framework for studying the Service Tax contribution to economic growth is as follows. An in-depth descriptive analysis of the trends and patterns of service taxation in India is initially carried out, in terms of growth rates and percentage shares. Afterwards, the income elasticity of service tax revenue collection in India is estimated, by applying the cross-sectional time-series FGLS (Feasible Generalised Least Squares) regression. Since time-series data on service tax revenue collection is available only for few years (less than twenty), panel-data on service taxation is used for the econometric analysis. Pooled FGLS imposes a common coefficient vector on a panel-data model. Pooled FGLS is more efficient than Pooled OLS, under the groupwise homoscedasticity assumption. Since service tax is a consumption-based tax, the 30

4 growth trend in Services Private Final Consumption Expenditure (PFCE) is studied, and the relationship between service tax collection and services PFCE is also examined. The changing composition of India s service tax revenue basket since is also analysed descriptively, using percentage shares. This is done based on the GDP classification put forth by CSO. A comparative analysis of the major service sub-sectors contributing to India s private services GDP and service tax revenue collection is carried out, and implications are drawn. Data on service tax revenue collection published by Directorate of Service Tax, Ministry of Finance, is used for this empirical analysis. The service sector contribution to employment generation and growth is analysed as follows. First of all, the trends in usual status employment across primary, secondary and tertiary sectors are analysed descriptively for the Indian economy, since the 1980s. Afterwards, the major sub-sectors absorbing most of the service sector workforce in the country is identified, and their changing sectoral shares are analysed. The employment elasticities and growth rate in average wages across various subsectors of India s service sector is then analysed. Finally, the quality of employment within the service sector is studied, by examining the role of informal employment. The distribution of informal employment across various service sub-sectors is analysed, by making a distinction between rural and urban areas. Employment data published by NSSO during various rounds of the Employment and Unemployment Surveys is used for this empirical analysis. The contribution of non-factor services and other invisibles towards India s external stabilisation is studied by making an in-depth analysis of the contribution of different components of India s invisibles balance and net services exports at a disaggregate level, from to The focus of this analysis is to find out which of the components have played a bigger role in India s external stabilisation during the last three decades, and especially during the recent global economic recession of A comparison of the contribution of services trade and private transfers in bringing down India s current account deficit is also carried out. Empirical analysis is carried out with the help of growth rates and percentage shares, utilising balance of payments data from the Handbook of Statistics on Indian Economy published by Reserve Bank of India. 31

5 2.3 Empirical Results Services GDP and Economic Growth Decomposition of the Service Sector Contribution to India s Economic Growth The service sector contribution to India s economic growth is assessed with the help of the methodology used by Jalava and Pohjola (2002). That is, the aggregate economic growth of the Indian economy ( Y ˆ ) is taken to be the sum of (i) shareweighted output growth of the service sector, Y 1ˆ and (ii) share-weighted output growth of the rest of the economy, Ŷ 2 (i.e., agriculture and industry). In equation (2.1), the weight w 1 gives the share of services value-added in aggregate output, and w 2 gives the share of agriculture and industry value-added in aggregate output. Yˆ wyˆ wyˆ (2.1) where w 1 w2 1 For the time-span of this study, the average share of service sector value-added in India s total GDP at constant ( ) prices is found to be w 1 = 0.47, and the average share of agriculture and industry value-added in India s total GDP at constant prices is found to be w 2 = The annual growth rates of services GDP and rest of the economy GDP ( Y 1ˆ and Y ˆ 2 ) is also calculated. Table 2.1 gives the results. 32

6 Table 2.1: Output Share-weighted Decomposition of India s Economic Growth ( to ) Year Services GDP Growth Rate wy 1 1ˆ Agriculture + Industry GDP Growth Rate wy ˆ 2 2 Indian Economy's Growth Rate wyˆ wyˆ Service Sector Contribution to India s Economic Growth wyˆ ˆ ˆ wy 1 1 wy AVERAGE Source: Author s calculations Figure 2.1 plots the changing service sector contribution to India s economic growth, over the past three decades. From the output share-weighted decomposition of India s 33

7 economic growth, it is found that the service sector contribution exceeded 40 percent during majority of the study-period, except for a few outliers in the 1980s. The output-share weighted growth rate of service sector averaged 3.7 percent during the study-period, whereas the corresponding growth rate for the rest of the economy averaged 2.6 percent. Indian economy is thus found to grow at an average rate of 6.3 percent during the time-span of our interest. Service sector contributed more than 90 percent to India s economic growth during two years and , and contributed nearly 100 percent in Service sector contribution to India s economic growth even exceeded 100 percent in , when rest of the economy (sum of agriculture and industry) output registered a negative growth rate in the aftermath of the economic crisis. It is also found that the service sector contribution to India s economic growth averaged 63.5 percent during the entire study-period. Therefore, it can be inferred conclusively that service sector is a crucial component in India s growth story during the last three decades; and has contributed in a much bigger way to India s economic growth, compared to agriculture and industry put together. Source: Author s calculations based on data from National Account Statistics (NAS), various years 34

8 Identification of the Major Sub-sectors Contributing to Service Sector GDP This section analyses where exactly within the service sector is growth originating from, and what explains this growth. The empirical analysis is carried out for the time-span from to When the contribution of publicly-owned and privately-owned services in India s total service sector GDP is compared, it is found that privately-owned services occupy a high share in India s Services GDP. The share of privately-owned services in service sector GDP is found to average 65 percent in the 1980s, 66 percent in the 1990s, and 68 percent in the 2000s. It is evident from these statistics that privately-owned services have been driving India s service sector growth during the last three decades. Figure 2.2 shows the percentage share of different components in India s private services GDP during the study period. It is found that trade, hotels and restaurants contributed the highest share of about 40 percent to India s private services GDP throughout the entire 32 year time period. Finance, insurance, real-estate and business services occupied the second spot, in terms of contribution to private services GDP. Their share in India s private services GDP is found to peak in the 1990s at around 30 percent, after which it slightly declined in the 2000s. During the time span from to , the contribution of transport, storage and communications to India s private services GDP is found to exhibit a rising trend. The share of transport, storage and communications in private services GDP increased from 11 percent in to 21 percent in On the other hand, the contribution of community, social and personal services to private services GDP has proportionately declined during the same time period. The share of this component in India s private services GDP declined from 21 percent in to 12 percent in

9 Source: Author s calculations based on data from NAS, various years 36

10 Source: Author s calculations based on data from NAS, various years Figure 2.3 throws light on the sub-sectoral shares within (a) trade, hotels and restaurants and (b) finance, insurance, real-estate and business services, to identify which are the major sub-sectors contributing to private services GDP during to It is found that domestic wholesale and retail trade and real-estate, ownership of dwellings and business services are the two key sub-sectors which contributed to India s private services GDP during this 32 year period. The share of domestic wholesale and retail trade in private services GDP averaged 38 percent during this period. The share of real-estate, ownership of dwellings and business services in private services GDP averaged 22 percent during to The share of hotels and restaurants in private services GDP is found to be quite negligible and averaged 3 percent during the same period. Banking and insurance managed to double its share in private services GDP during this 32 year period, from 4 percent in to 8 percent in

11 Table 2.2: Growth Rate of Components of India s Services GDP: to GDP Categories CAGR to Services GDP 7.77 Services GDP (Private sector) 7.96 Services GDP(Public sector) 7.39 Trade, Hotels & Restaurants (Private sector) 7.65 Transport, Storage & Communication (Private sector) Finance, Insurance, Real-estate & Business services (Private sector) 8.31 Community, Social & Personal services (Private sector) 6.01 Wholesale and Retail Trade (Private sector) 7.66 Hotels & Restaurants (Private sector) 7.94 Banking & Insurance (Private sector) Real-estate, Ownership of dwellings & Business services (Private sector) 7.84 Source: Author s calculations based on data from NAS, various years Table 2.2 shows the Compound Annual Growth Rate (CAGR) of different components of India s private services GDP, calculated for the time-span of this study. It is found that sectors such as (1) transport, storage and communication, and (2) banking and insurance, whose share in the country s private services GDP is relatively small, have registered the highest growth rates during the 32-year period, from to Privately-owned transport, storage and communications services witnessed a CAGR of percent during this time period, whereas privately-owned banking and insurance services witnessed a growth rate of percent during the same period. On the other hand, privately owned domestic trade registered a CAGR of 7.66 percent and privately owned Real-estate, Ownership of dwellings & Business services registered a CAGR of 7.84 percent during this 32 year period. Despite their relatively low growth rates, domestic wholesale and retail trade and real-estate, ownership of dwellings and business services continue to be the biggest contributors to privately-owned services GDP in terms of percentage shares, for more than three decades from to This analysis implies that economic reforms and opening up of the economy in the early 1990s didn t have much impact on the shares of these two sub-sectors in India s private services GDP, which have remained more or less the same throughout the 32 year time-span. 38

12 Explanation for High Share of Wholesale and Retail Trade and Real-estate, Ownership of Dwellings and Business Services in India s Private Services GDP From the review of literature in the first chapter of this thesis, it was found that both demand-side as well as supply-side factors operate leading to a high share of services in a country s GDP. The demand side factors include (1) higher income elasticity of demand for final product services, (2) slower productivity growth in services leading to a higher employment potential and (3) structural changes within the manufacturing sector, which makes contracting out services more efficient than producing them within the firm or household. Bhagwati (1984) called this contracting out process as splintering. The supply-side factors include (1) increased exports (2) higher FDI in services and (3) improved technology. The demand-side factors of splintering and slower productivity growth in services which lead to higher employment potential is best suited to explain the high share of domestic wholesale and retail trade in Services GDP. Greenfield (1966) and Francois (1990) argued that demand for producer services in total intermediate demand by manufacturing firms grows as they expand, because higher specialisation is more profitable. With technological progress and development, services also become more crucial to coordinate production processes; to create and absorb new innovations and to increase the benefit-extracting capacity in production and consumption. All these result in a higher use of services in the growth process. The growing complementarity between the manufacturing and services sector in the Indian context is empirically examined in studies such as Hansda (2001) and Banga and Goldar (2004). Since, domestic wholesale and retail trade is universally classified as a producer service, splintering is a possible explanation for the high share of this sub-sector in India s private services GDP. Kaldor (1966) argued that there exists a negative relationship between labour productivity growth in the economy as a whole, and the productivity growth in the non-manufacturing sector (Verdoon s Law), mainly because agriculture and many service activities are subject to diminishing returns. Baumol (1967) further argued that due to their labour-intensive nature, service sector activities cannot be made more efficient through capital accumulation, innovation, or economies of scale. Slower productivity growth in services resulting in higher employment potential is another 39

13 possible explanation for the high GDP share of wholesale and retail trade in the Indian context. Trade, hotels and restaurants absorbed a major proportion of the service sector workforce in the country, both in rural as well as urban areas, as is evident from the various rounds of employment and unemployment surveys published by NSSO (Table 2.14). Most of the technological advancements accompanying economic reforms have occurred outside of this service sub-sector; in services such as finance, insurance, software and communications. This explains the slower productivity growth in domestic wholesale and retail trade and higher employment potential. Supply-side factors such as (a) increased exports and (b) higher FDI in services are better suited to explain the high share of real-estate, ownership of dwellings and business services in services GDP. Gordon and Gupta (2004) found out that India s services growth in the post-liberalisation period has been an export-led growth. Trade liberalisation and reforms had a favourable effect on growth of finance, real-estate and business services. Exports of business services such as software and consultancy services shot up in the 1990s. Business services and real-estate services are classified under the miscellaneous services category in India s balance of payments. The share of miscellaneous services in India s services export basket has increased significantly in the post-reform period, especially post 2000 (Figure 2.11). Increased export of business services and real-estate services is hence a plausible explanation for their high share in India s private services GDP. Service sector has succeeded in attracting the maximum amount of FDI into the country in recent years. The share of service sector in total FDI inflows into the Indian economy increased from 22.3 percent during , to 55.4 percent in 2012 (Table 2.4). The SIA newsletters published by Ministry of Commerce, provides sectorallevel data on FDI inflows. The SIA definition of services includes financial, banking, insurance, business services, outsourcing, R & D, courier, technical testing and analysis and other services. Share of housing and real-estate and business services in total FDI inflows into Indian economy have exhibited a rising trend during the last one decade, benefiting from policy initiatives aimed at privatisation and liberalisation (Table 2.5). Higher FDI inflows is thus a plausible explanation for their high share in India s services GDP. In contrast, the share of wholesale trading 40

14 and retail trading in India s total FDI inflows remained negligible below 3 percent during the twelve year period from 2000 to Thus, increased FDI inflows cannot explain the high share of domestic wholesale and retail trade in India s services GDP, during the time-span of this study Investment in Service Sector and Economic Growth Investment occupies an important role in a country s economic growth, by raising the productive capacity of the economy, generating employment opportunities, promoting technological innovation, and adding to the government s tax revenues. The Solow- Swan Neo-classical growth model emphasised the role of capital accumulation in determining the growth rate in the short-run, as the economy moves towards a new steady state. As per the expenditure approach to national income accounting, Gross Domestic Product at market prices is the sum of private final consumption expenditure, investment, government spending and net exports of goods and services. Therefore, investment is a key ingredient for economic growth. India has a remarkable savings-investment profile in comparison with other countries at similar per-capita income levels. This was achieved in the early years by policy initiatives such as nationalisation of banks in 1969, which resulted in opening up of bank branches across the length and breadth of the country, and facilitated the transformation of savings to investment. During the Early Five Year Plans, government took the lead in investment, and public sector dominated in core strategic, infrastructure and industrial sectors, whereas private investment was confined to residual sectors. It resulted in a high incremental capital-output ratio, implying low marginal efficiency of investment which came in the way of achieving a higher rate of economic growth. However, private investment immensely benefited from the economic reforms and liberalised policy environment of the 1990s, especially with the opening up of the Indian economy to Foreign Direct Investment. A high investment rate, averaging more than 36 percent of GDP supported India s impressive growth rate of 8.2 percent during the 11th Five-Year Plan period ( ). The approach paper to the 12 th Five Year Plan of Government of India (GOI 2011) envisages an even higher investment rate (measured as gross capital formation as a percentage of the country s GDP) of 38.4 percent and 41.4 percent, commensurate with a higher growth target of 9 percent and 9.5 percent respectively. 41

15 It is a well-established fact that India has been witnessing a structural transformation over the past thirty years, with the rising share of service sector in the country s GDP. Mallick (2009) found a similar scenario of structural transformation happening in the Indian economy, with regard to private investment. He found a declining trend in the share of agriculture in India s growth in private investment, whereas the shares of industry and service sector have become prominent. UNCTAD (2004) also noted the sectoral shift towards services world-wide, with regard to Foreign Direct Investment. Moreover, the rate of service sector capital formation in the Indian economy which was about percent in the 1980s and 1990s rose to an average of 25 percent in the last decade. There are two major kinds of investment, public investment and private investment. Private investment is mainly undertaken with a profit motive, and involves replacement of the existing capital stock, and creation of additional capital stock embodying new technology. Public investment, on the other hand, is discretionary, and is driven by government policies. Public investment is broadly of four types - investment in infrastructure; investment in human capital; investment in technical progress, say in R & D; and investment in plant and equipment (Lloyd 1999) Identification of the Major Sub-sectors Contribution to Service Sector Investment When public and private contribution towards India s service sector investment is disaggregated for the purpose of this study, it is found that public sector capital formation within India s service sector was higher than that of private sector throughout the 1980s and early 1990s (except during the crisis year of ). Private investment within the service sector witnessed acceleration only in the mid- 1990s. Share of public sector in gross capital formation within the service sector is found to be 60 percent in the 1980s, which fell to about 45 percent in the 1990s, and further declined to 30 percent in the 2000s. On the other hand, private-sector share in total service sector capital formation is found to be 77 percent in Privatesector capital formation began to exceed public sector capital formation within the service sector from the year onwards (Figure 2.4). Therefore, the time-span of this study is divided into two sub-periods: to and to This is to get a better insight into the major service sub-sectors which have 42

16 contributed to public sector and private sector capital formation during this time period. Source: Author s calculations based on data from NAS, various years Table 2.3 shows the contribution of different sub-sectors towards public sector gross capital formation (GCF) for the time period from to , which roughly coincides with India s pre-liberalisation phase. Community Social and Personal Services is identified as the major subsector contributing to public sector investment within service sector during this period. Share of Community, social and personal services in public GCF was as high as 63 percent during this period. It is also found that investment rate in the public-sector is highest in community, social and personal services at percent. Transport, storage and communications closely followed with an investment rate of 23.6 percent. Table 2.3 also shows the contribution of different service sub-sectors towards private sector gross capital formation during the post-reform period from to Finance, insurance, real-estate and business services is identified as the major-subsector contributing to private sector GCF during this period. Share of Finance, insurance, real-estate and business services in private GCF averaged 46.8 percent during this period. Investment rate in the private sector is also found to be highest in finance, insurance, real-estate and business services at 27.8 percent. The pattern of private investment during the prereform phase and public investment during the post-reform phase is also highlighted in Table 2.3 for comparison purposes. It is found that the major sub-sectors in the public sector and private sector contributing to services capital formation have remained the same throughout the time-span of this study. However, even within 43

17 these major sub-sectors, it is found that the public investment rate has declined whereas the private investment rate has risen significantly during the post-reform phase, from to Table 2.3: Gross Capital Formation within Service Sector at Constant ( ) Prices Sub-sectors Trade, Hotels & Restaurants Transport, Storage & Communication Finance, Insurance, Real-estate & Business Services Community, Social & Personal Services Public Services GCF ( to ) Share in Public GCF Investment Growth Rate Private Services GCF ( to ) Share in Private GCF (in percent) Investment Growth Rate Sub-sectors Trade, Hotels & Restaurants Transport, Storage & Communication Finance, Insurance, Real-estate & Business Services Community, Social & Personal Services Public Services GCF ( to ) Share in Public GCF Investment Growth Rate Private Services GCF ( to ) Share in Private GCF (in percent) Investment Growth Rate Source: Author s calculations based on data from NAS, various years When public sector capital formation in community, social and personal services during the time-span from to is further disaggregated (Figure 2.5), it is found that investment in public administration and defence is the biggest contributor to public sector capital formation within the service sector during this phase. Similarly, when private sector capital formation in finance, insurance, realestate and business services during to (Figure 2.6) is disaggregated, it is found that investment in real-estate, ownership of dwellings and 44

18 business services is the biggest contributor to private-sector capital formation within the service sector during the post-reform phase. Source: Author s calculations based on data from NAS, various years GCF (in Rs. billion) Figure 2.6: Disaggregation of Private GCF in Banking, Insurance, Realestate & Business Services ( to ) 0 Banking & Insurance YEAR Real estate,ownership of dwellings & Business services Source: Author s calculations based on data from NAS, various years 45

19 Contribution of Service Sector to Foreign Direct Investment FDI is a valuable source of technology and management know-how, in-addition to the direct capital financing it supplies. It also fosters forward and backward linkages with local firms, thus helping to accelerate the economic growth of an economy. Sectorallevel data on FDI inflows into India is available only from the year 2000 onwards, and is published in the SIA newsletters of DIPP. However, the coverage of services in the SIA newsletters is different from the NAS definition of service sector. The SIA definition of services includes only financial, banking, insurance, business services, outsourcing, R & D, courier, technical testing and analysis and other services. Therefore, the coverage of services FDI is re-defined for the purpose of this study, to make it comparable to the NAS definition of service sector. Service sector FDI is redefined to be the sum of FDI inflows into (i) services, (ii) telecommunications, (iii) education, (iv) consultancy services, (v) information and broadcasting, (vi) hotels and tourism, (vii) trading, (viii) retail trading, (ix) hospitals and diagnostic centres, (x) airtransport, (xi) sea-transport and (xii) housing and real-estate. Based on this definition, it is found that the service sector share in India s total FDI inflows, which was only 22.3 percent during the 5-year period from ; has more than doubled since then and stood at 55.4 percent in 2012 (Table 2.4). Services FDI even exceeded 50 percent of the total FDI inflows into India in 2006, 2009 and The remarkable rise in the Foreign Direct Investment contribution of India s service sector during the post-2005 years is note-worthy. This is consistent with the FDI pattern witnessed world-wide of dominance of services (UNCTAD 2004). Table 2.4: Service Sector Share in Total FDI Inflows Calendar Year Share (in percent) Source: Author s calculations based on data from various issues of SIA newsletters, DIPP 46

20 Table 2.5 shows the changing share of major service sub-sectors in India s total FDI inflows. It is found that services and telecommunications were the major sectors attracting FDI inflows during the 5-year time period from , with a share in total FDI of 8 percent and 7.6 percent respectively. The services (as per SIA definition) share in total FDI inflows witnessed a phenomenal increase to 35 percent in 2006, and it emerged as the major contributor to FDI. However, the services share in total FDI has been exhibiting a falling trend since then. On the other hand, the share of telecommunications in total FDI has increased only marginally post-2005 and remained below 10 percent. The SIA definition of telecommunications includes radio-paging, cellular mobile and basic telephone services. It is also found that the share of housing and real-estate in total FDI inflows increased steadily after 2005 and attained a peak of 12 percent in Although its share fell drastically to 2.4 percent in 2011, FDI inflows into housing and real-estate recovered to an impressive 10.5 percent of total FDI in Table 2.5: Share of Different Service Sub-sectors in India s Total FDI Inflows Calendar Year Services Tele communications Consultancy Services Education Information & Broadcasting Hotels & Tourism Calendar Year Wholesale Trading Retail Trading Hospitals & Diagnostic Centres Air Transport Sea Transport Housing & Real-estate Source: Author s calculations based on data from various issues of SIA newsletters, DIPP 47

21 Many service sub-sectors such as telecommunication, consultancy services, information and broadcasting, retail-trading, and housing and real-estate managed to attract maximum FDI inflows during the year 2009 (Table 2.5). However, their shares in total FDI inflows fell post 2009, which has been taken up by sectors such as hotels and tourism, which has emerged as an attractive destination for FDI in 2012, with a share of 14.9 percent. Nevertheless, services continue to retain its top rank as the sub-sector which succeeded in attracting maximum FDI inflows into India even in the year Telecommunications retained its second rank as a popular destination for FDI inflows in 2011, but hotels and tourism bagged the second rank in Contribution of housing and real-estate to total FDI inflows exceeded that of telecommunications during the years 2007, 2009 and 2012 (share in total FDI nearly same for both sectors in 2010) Analysis of Investment Contribution of Service Sector to India s Economic Growth For examining the contribution of service sector investment to India s economic growth, the correlation matrix between the relevant variables is initially calculated. Table 2.6 gives the inter-correlation coefficients between services GCF, total GCF and total GDP for the 32-year period, from to The correlation coefficients are found to be positive and statistically significant, implying the existence of a strong positive relationship between these three variables. The correlation coefficient between service sector GCF and total GDP is found to be slightly higher than the correlation coefficient between total GCF and total GDP. Here, service sector GCF is the sum of public sector GCF and private sector GCF in service sector, and private sector GCF includes both domestic investment as well as foreign investment in service sector. Table 2.6: Correlation Matrix of Investment and GDP for Indian Economy: to Capital Formation Total GDP at Factor Cost Service sector GCF 0.99 Total GCF 0.98 Source: Author s calculations based on data from NAS, various years 48

22 The next step is to quantify the contribution of service sector investment to India s economic growth. The expenditure approach to national income accounting is utilised to analyse the contribution of service sector investment to India s economic growth. Table 2.7 gives the growth rates and the contribution of different components of India s GDP at market prices, during the pre-reform phase ( to ) and post-reform phase ( to ). It is found that Gross Capital Formation is the only component of GDP which has contributed significantly to the increase in India s GDP at Market Prices during the post-reform phase, in comparison with the pre-reform phase. The contribution of GCF to increase in India s GDP at Market Prices was percent during to , which almost doubled to percent during the time-span from to Private Final Consumption Expenditure (PFCE) contributed more than 50 percent to the increase in India s GDP at Market Prices during both the phases. Although PFCE continues to be biggest contributor, it is found that there is only a small increase in the contribution of PFCE to the increase in GDP during the post-reform phase, compared to pre-reform phase. On the other hand, the contribution of Government Final Consumption Expenditure (GFCE) to increase in India s GDP even declined during post-reform phase. Table 2.7: Expenditure Approach to GDP at Market Prices (at constant prices) Components of GDP at Market Prices to to Contribution to increase in CAGR GDP* CAGR Contribution to increase in GDP* (in percent) GDP at Market Prices PFCE GFCE GCF Services GCF Industry GCF Agriculture GCF Exports of Goods and Services (less) Imports of Goods and Services Source: Author s calculations based on data from NAS, various years. * Contribution to increase in GDP is calculated as (final-initial value of each component / final-initial value of GDP). Note: Sum of different components of GDP does not add up to 100 due to statistical discrepancies. 49

23 When the contribution of GCF to increase in India s GDP at Market Prices is further dis-aggregated in Table 2.7, it is found that this phenomenal increase in the contribution of India s GCF witnessed in the post-reform phase can mostly be attributed to the rise in capital formation within industry, and in service sector to a lesser extent. The contribution of industry GCF to increase in India s GDP is found to be the highest during both the phases, followed by service sector. Contribution of industry GCF to increase in India s GDP almost doubled to percent during the post-reform phase, compared to percent in the pre-reform phase. Contribution of service sector GCF to increase in India s GDP at Market Prices also increased moderately from 9.06 percent in the pre-reform phase, to percent during to It is found that the contribution of agriculture GCF to increase in India s GDP has been insignificant during both the phases, compared to industry and services. When the Compound Annual Growth Rate (CAGR) of different components of India s GDP at Market Prices is compared, it is again found that Gross Capital Formation witnessed the biggest hike in CAGR from 5.11 percent in the pre-reform phase, to 9.55 percent during the post-reform phase. On further dis-aggregation of GCF, it is found that Industry GCF registered the highest CAGR of 6.59 percent during pre-reform phase, and 9.81 percent during the post-reform phase. This reinforces the earlier finding that industry GCF has contributed in a much bigger way to India s economic growth, compared to service sector GCF. Table 2.8: Incremental Capital-Output Ratio (ICOR) of Service Sector and Indian Economy Time Period Service Sector Indian Economy 1980s s s to to Source: Author s calculations based on data from NAS, various years To get a better understanding of the contribution of service sector investment to India s economic growth, this study delves further and computes the incremental capital-output ratio (ICOR) for India s service sector, and estimates the growth rate of service sector using Harrod-Domar Model. Table 2.8 gives a comparative picture of the ICORs for the service sector and the Indian economy during the last three decades, and also for the two time-spans relevant for this study. ICOR is computed 50

24 based on the Planning Commission formula, which is (GFCF Sum/GDP difference), computed over the time-span under consideration. It is found that the ICOR of India s service sector declined drastically, from 3.6 during the pre-reform phase to 3.0 during the post-reform phase. An important implication that follows is that during the postreform phase ( to ), when private investment dominated capital formation within the service sector, service sector output is found to have lesser capital intensity. The ICOR of the Indian Economy also fell from 4.8 during to , to 4.4 during to It is also found that the gap between the ICORs of the service sector and the Indian economy widened during the postreform phase. The capital intensity of India s service sector output is found to have declined progressively during the 1980s, 1990s and 2000s, as is evident from Table 2.8. The ICOR of Indian economy is found to increase from 4.5 in the 1980s to 4.7 in the 1990s, which again reverted back to 4.5 in the 2000s. 51

25 Table 2.9: A Comparison of Actual Growth Rate and Predicted Growth Rate of Service Sector from Harrod-Domar Model Year Investment Estimated Growth ICOR Rate (i) Rate = i/icor Actual Growth Rate Source: Author s calculations based on data from NAS, various years The Harrod-Domar Model relates the growth rate (g) of an economy to its savings rate(s) and the incremental capital-output ratio (c), wherein g = s/c. But data on savings rate for India s service sector is not available at the all-india level. The equilibrium condition in the Harrod-Domar model equates savings to investment. Therefore, it is possible to compute the growth rates for the service sector with the help of Harrod-Domar Model, by utilising information available on investment rates and incremental capital-output ratios. Table 2.9 gives a comparative picture of actual growth rates and the growth rates estimated using Harrod-Domar Model, for India s service sector. Actual growth rates of India s service sector are found to be higher than the growth rates predicted from Harrod-Domar model, during most of the years. 52

26 Divergence between the growth rates can be explained in terms of ICOR or investment rate. Given the investment rate of service sector, if ICOR is underestimated, growth rate estimated using Harrod-Domar Model becomes equal to the actual growth rate of service sector. Given the ICOR of service sector, if investment rate is overestimated, both the predicted growth rate as well as actual growth rate of service sector becomes equal Service Tax Contribution to Economic Growth Service tax was introduced in India in , in accordance with the provisions of Finance Act of 1994, of the Constitution. Service tax is an indirect tax levied by the Central Government in India. Introduction of service tax in the country ushered in a major structural change in the indirect tax regime, in the form of a wider tax-base and facilitated the process of rationalisation of excise duties, resulting in lower tax burden on productive sectors (GOI 2011). India has been following the positive list approach to service taxation for past 18 years (from to ). The positive list provides a detailed description of each taxable service, and all other unspecified services are not liable to be taxed. The positive list approach to service taxation has the advantage of definitiveness, which is an essential pre-condition for a good taxation law. This selective system of taxation of services in the form of incremental additions over the years, has served well in the past in familiarising both the tax-payers and tax administrators to this levy Trends in Service Tax Revenue Collection for Indian Economy Table 2.10 shows the empirics of service tax revenue collection in India, during the eighteen years since its inception. Service tax collection has gone up from a modest Rs. 4.1 billion in , to more than Rs. 975 billion in This can be mostly attributed to the quantum jump both in the number of services taxed, as well as the number of tax assessees. The number of services taxed shot up, from just 3 services in (namely, telecommunications, non-life insurance and stockbrokers); to 119 services in The number of service tax assessees have also increased substantially during this time-span, from 3943 assessees in , to 1.5 million assessees by Most of the growth in the number of service tax assessees happened during the initial few years after imposition of the tax, especially 53

27 , and , when the growth rates registered were more than 100 percent. Financial Year Table 2.10: Trend in Service Tax Revenue Collection in India Revenue (Rs. Billion) Simple Annual Growth Rate (in percent) Number of Services Under Tax Net Number of Tax Assessees Simple Annual Growth Rate (in percent) Base Year Base Year Source: Directorate of Service Tax (DST), Ministry of Finance, Government of India When the simple annual growth rates in service tax revenue collection are compared, it is found that the year witnessed a mind-boggling 106 percent growth in service tax revenue collection. But this is mainly because of the base-year effect, since service tax was introduced in India just the previous year. In , service tax revenue collection registered an impressive growth of 91 percent over the previous year. The hike in the tax rate from 8 percent to 10 percent, coupled with the phenomenal increase in the number of tax assessees in over the previous year, explains this impressive growth in service tax revenue. Growth in service tax collection has exhibited a declining trend since then, and even dipped to a negative simple annual growth rate of -3.9 percent in This shocking decline can be solely attributed to the global economic recession of , because of which the Government of India had to reduce the service tax rate from 12 percent to 10 percent, as a part of its fiscal-relief package. However, service tax revenue collection registered a simple annual growth rate of 22 percent in , mainly due to the 54