Financial sector and tax reforms

Detail

1. What the financial sector is

• Financial sector = the institutions that move money from savers to borrowers:
• commercial banks (take deposits, give loans)
• investment banks (help companies raise money by selling shares and bonds)
• stock exchanges (markets where shares are bought and sold)

• foreign exchange (forex) market (where rupees are exchanged for dollars and other currencies)

• The Reserve Bank of India (RBI) regulates this sector. It sets the rules and checks that banks follow them.

2. The RBI's role: "from regulator to facilitator"

• Before 1991, the RBI controlled small details (micro-controls):
• how much money banks had to keep with themselves (the reserve ratios)
• the interest rates banks charged and paid

• which sectors got loans, and how much (directed lending)

• After 1991, the RBI became a "facilitator":

• Banks now take many decisions without asking the RBI, for example on interest rates, branches and lending.

• They must stay within prudential norms (safety rules that keep a bank healthy, such as capital and bad-loan rules).

• The RBI is still the regulator. It keeps control over managerial matters "to safeguard the interests of the account-holders and the nation" (Class 11).

• The reform package also:
• allowed private and foreign banks
• raised foreign investment limits

• allowed FIIs to invest in Indian markets

• See the banking-regulation-npas note for NPAs and Basel norms.

3. The Narasimham Committees: from micro-controls to prudential regulation

• Narasimham Committee I (1991), the "Committee on the Financial System", was set up just after the balance of payments (BoP) crisis. Its advice became the base for reforms in banks, development financial institutions (DFIs) and the capital market [4].
• Narasimham Committee II (1998), the "Committee on Banking Sector Reforms (CBSR)", gave its report in April 1998. It set the plan for the second phase of bank reform [4][5].

Key terms

• SLR (Statutory Liquidity Ratio) = the share of a bank's deposits that it must keep in safe, liquid assets, mainly government securities.
• CRR (Cash Reserve Ratio) = the share of deposits that a bank must keep as cash with the RBI. The bank earns no interest on this money.
• Formula: Money free for lending ≈ Deposits × [1 − (CRR + SLR)]

Worked example: why high CRR and SLR hurt lending

• A bank has deposits of ₹100 crore.
• Before reform (CRR 15%, SLR 38.5%):
• Locked money = 15 + 38.5 = ₹53.5 crore.

• Only ₹46.5 crore is left to lend to farmers and firms.

• After reform (SLR 25%, with CRR assumed at 10% for this example):

• Locked money = ₹35 crore.

• ₹65 crore is free to lend.

• The chain: lower reserves → more money for loans → more investment → faster growth.

• A high SLR also meant banks were forced to fund the government's deficit.

Area	Before	After
SLR	38.5% (statutory peak). The average effective rate was 37.4% (1992) [4]	Committee I advised cutting it to 25% over five years. It reached the 25% statutory minimum (1997) [4]. It is lower today.
CRR	15%	Committee I advised a progressive (step-by-step) reduction [4]. Single digits later (verify the current rate on rbi.org.in).
Interest rates	Administered (fixed by the RBI)	Largely deregulated: banks set their own rates
Prudential norms	Weak	Income recognition, asset classification and provisioning, introduced in phases [4][5]. CRAR 8%
Branch licensing	RBI approval needed	Banks that meet the conditions can open or close branches freely

The prudential norms explained

• Income recognition: a bank cannot count interest as income unless it actually receives it. Loans that stop paying become NPAs (non-performing assets).
• Asset classification: loans are sorted into standard, sub-standard, doubtful and loss.
• Provisioning: a bank must set aside money from its profit to cover loans that may go bad.
• CRAR (Capital to Risk-weighted Assets Ratio):
• Formula: CRAR = (Bank's own capital ÷ Risk-weighted assets) × 100
• Example: a bank has capital of ₹8 crore and risk-weighted assets of ₹100 crore, so CRAR = 8%. Riskier loans get a higher weight, so they need more capital.
• Committee I set a first target of 4% by March 1993 [4]. This was later raised to 8% (NCERT scaffold).

4. New players and new institutions

Banking

• New private banks came under the 1993 RBI guidelines: ICICI, HDFC, UTI Bank (now Axis Bank), IndusInd and others.
• Foreign banks expanded their branches.
• FDI limits in banks:
• private banks: about 74% (NCERT: "around 74 per cent")
• public sector banks: 20%

Capital market

• FIIs (Foreign Institutional Investors) were allowed from 1992. Examples are merchant bankers, mutual funds and pension funds.
• They bring foreign money into Indian shares and bonds.

• But this "hot money" can also leave quickly.

• SEBI (Securities and Exchange Board of India) became a statutory body (one created by an Act of Parliament) in 1992. It regulates stock markets and protects investors.

• Controller of Capital Issues (CCI) was abolished in 1992.
• Before this, the government decided the price at which a company could sell its new shares.

• Now companies price their own issues, and SEBI requires them to disclose information.

• NSE (National Stock Exchange) was incorporated in 1992 and began trading in 1994. It brought screen-based (electronic) trading across the country.

Insurance

• The Malhotra Committee (1994) recommended opening insurance to private companies.
• The IRDA Act 1999 created the Insurance Regulatory and Development Authority, ending the public-sector monopoly of LIC and GIC.

5. Tax reforms: fiscal policy basics

• Fiscal policy = the government's policy on taxing and spending.
• Direct tax = a tax on the income of individuals or the profits of firms. The person who pays it bears it. Examples: income tax, corporation tax.
• Indirect tax = a tax on goods and services. The seller collects it and passes it on to the buyer. Examples: excise duty, VAT, GST.

6. Direct tax reform: the Chelliah Committee (1991)

• Tax Reforms Committee under Raja Chelliah (1991). Its main idea: moderate rates lead to less tax evasion (illegally hiding income to avoid tax), and to more saving and voluntary disclosure of income.
• Why lower rates can bring in more tax:
• When rates are very high, people find it worth hiding income.
• When rates are moderate, paying tax costs less than the risk of being caught.

• So more people pay, the tax base (total income on which tax is collected) grows, and revenue can rise.

• Worked example:

• Someone earns ₹10 lakh.
• At a 40% rate, the tax is ₹4 lakh, so hiding the income "saves" ₹4 lakh.

• At 30%, hiding saves only ₹3 lakh, which is less reason to take the risk.

• Personal income tax peak rate: 40% (1992-93) → 30% (1997-98).

Corporation tax (the tax on company profits) was cut in steps. The big change came in 2019:

• The Taxation Laws (Amendment) Ordinance, 2019 was later replaced by the Taxation Laws (Amendment) Act, 2019 [8][9].
• Section 115BAA: any domestic company may choose to pay 22%, if it gives up exemptions and incentives. The provision applies from 1 April 2020 [6][9].
• Section 115BAB: new domestic manufacturing companies incorporated on or after 1 October 2019 may choose to pay 15% [7].
• Rules on switching:
• Once a company chooses 115BAA, it cannot withdraw that choice in later years [6].

• A company that loses 115BAB eligibility can move to 115BAA [7].

• Logic: low rates with no exemptions give a simple tax, fewer disputes and more investment, especially in "Make in India" manufacturing.

7. Indirect tax reform: towards a common national market

• The problem before reform: "tax on tax" (cascading).
• Each stage of production paid tax on the full price, including the tax already paid at earlier stages.

• Each State also had different taxes, which split India into many small markets.

• The answer: input tax credit, meaning a firm subtracts the tax already paid on its inputs from the tax it owes. This is value-added taxation.

• Worked example:
• A shirt maker buys cloth for ₹100 and pays ₹5 tax on it.
• The maker sells the shirt for ₹200, with ₹10 tax due.

• With input tax credit, the maker pays only ₹10 − ₹5 = ₹5, which is tax on the ₹100 of value added.

• Timeline:

• MODVAT (1986) → CENVAT (2000-01): credit for central excise
• Service tax (1994)
• State VAT (April 2005)

• 101st Constitutional Amendment (2016) → GST from 1 July 2017: "one nation, one tax, one market"

• What GST was expected to do: raise revenue and reduce evasion. The invoice chain helps here: a buyer can claim credit only if the seller has reported the sale.

GST 2.0: rate rationalisation (2025)

• The 56th GST Council meeting (September 2025) was chaired by Union Finance Minister Nirmala Sitharaman. It approved the "Next-Gen GST" reforms [2][3].
• Old structure: four slabs of 5%, 12%, 18% and 28%.
• New structure: two main rates [2]:
• 5% (merit rate)

• 18% (standard rate)

• Special 40% rate for sin and luxury goods: pan masala, tobacco, aerated drinks, high-end cars, yachts and private aircraft [2].

• New rates took effect from 22 September 2025 [2][3].
• (NCERT scaffold: "two main slabs of 5% and 18%, plus a higher rate for demerit goods". This is now confirmed.)

8. Simplification

• Easier procedures and lower rates were meant to improve tax compliance (people and firms paying their taxes honestly and on time).
• GST mechanics (CGST, SGST, IGST and the GST Council under Article 279A) are covered in the taxation note.

Prelims Hooks

• SLR = share of deposits held in government securities. CRR = cash held with the RBI. Before reform: 38.5% and 15%.
• Narasimham Committee I (1991) was the "Committee on the Financial System". Committee II (1998) was on Banking Sector Reforms [4].
• Committee I aimed to cut SLR to 25% over five years. Its first capital adequacy target was 4% by March 1993, later raised to 8% CRAR [4].
• CRAR = Capital ÷ Risk-weighted assets × 100.
• SEBI became statutory in 1992. The CCI was abolished in 1992. NSE was incorporated in 1992 and began trading in 1994. FIIs were allowed from 1992.
• Malhotra Committee (1994) → IRDA Act 1999, covering insurance.
• Chelliah Committee (1991), on tax reform: peak personal income tax fell from 40% (1992-93) to 30% (1997-98).
• Corporate tax: Section 115BAA = 22% (any domestic company, no exemptions). Section 115BAB = 15% (new manufacturing companies incorporated on or after 1 October 2019) [6][7].
• GST: 101st Amendment (2016), launched 1 July 2017. The 56th GST Council moved to 5% and 18%, plus 40%, effective 22 September 2025 [2].
• Trap: "After 1991 the RBI stopped being the regulator." This is false. It became a facilitator but is still the regulator.

Mains Points

• Prudential regulation vs micro-control:
• Lower SLR and CRR freed bank money for private investment, and deregulated interest rates improved efficiency.
• But the weak credit checks of the 2000s-2010s led to the twin balance sheet problem (high NPAs in banks and heavy debt in companies).

• Lesson: a "facilitator" RBI still needs strong supervision.

• Financial openness brings both gains and risks:

• FII and FDI limits brought capital and technology.
• But FII money can leave quickly, as in 2008 and 2013, which is a risk to the current account and the rupee.

• Liberalisation needs strong regulators (SEBI, IRDAI) and forex reserves to go with it.

• Tax reform logic (Chelliah → 2019 corporate cut → GST 2.0):

• Low rates, a broad base and few exemptions reduce evasion and disputes.
• The trade-off: less revenue in the short run, and a larger share of indirect tax, which falls more heavily on the poor.

• The 2025 rationalisation tries to balance simplicity, relief for the common person, and revenue through the 40% sin rate.

• Cooperative federalism:

• GST made India a common national market.
• But States gave up their own power to tax, so the GST Council has become a key forum for Centre-State bargaining (GS-II link).