After three decades of the assault on taxes thanks to the Reagan-Thatcher free-market consensus, it would seem that tax increases have finally stepped out of the shadows with a flourish. The global economic crisis has forced nations to pursue expansionary fiscal policies, which have raised their public debt and fiscal deficits enormously. A combined fiscal deficit of at least 11% of gross domestic product (GDP) has left the new government in India with limited fiscal space for any more of this much-needed stimulus spending. The rationale and the circumstances for increasing marginal income-tax (I-T) rates, or the rate for the highest tax slab, have thus never been clearer nor more favourable.
Yet, with tax cuts being the touchstone for the popular acceptance of any Indian budget, the new government could find itself pushed against the wall as it readies itself to present its first budget. Proponents of tax cuts argue that we are among the highest taxed nations, making our businesses uncompetitive. Well-respected commentators indulge in sophistry, reasoning that some of the gains from the robust growth in tax revenues in recent years should be passed on to the taxpayers by lowering taxes. Such claims are specious, self-serving and smack of deception.
Any debate on rationalizing taxes revolves around two parameters: the taxation slab rates and the incomes (or profits) at which the tax rates kick in. However, the campaign to rationalize these parameters often tends to get hijacked by those who advocate lowering of the marginal tax rate and adding to the web of tax exemptions. It is, therefore, important to distinguish between rationalizing tax slabs, which is desirable, and lowering the marginal tax rate, which is not.
Our tax system is riddled with exemptions that are effective subsidies to specific categories of taxpayers. Accordingly, companies paid an effective tax rate of only 20.6% in 2007-08. Our information technology companies and business process outsourcing firms pay some of the lowest tax rates anywhere in the world (at 6% and 7%, respectively). The revenue forgone was a whopping Rs3,37,060 crore, or about 58% of actual tax collections.
Among comparable nations, our richer citizens and businesses are one of the least taxed. At 33.99% each, we have the second lowest marginal corporate tax rates among the Group of Twenty (G-20) nations and one of the lowest marginal I-T rates across major economies (far lower than China’s 45%). Our tax-to-GDP ratio of 12.5 is among the lowest in the world.
Our welfare and investment needs are staggering and our resources scarce. The Planning Commission has estimated that we need to invest $500 billion, or almost half our GDP, over the next five years in infrastructure alone. To put this in perspective, nearly 60% of our total tax collections in 2007-08 ($145 billion) went into welfare transfers and interest payments.
The entire allocation for the social sector in 2007-08 was Rs95,919 crore, precious little for a country where 70-80% of population depends on the government for basic services. The limited headway with private investments in infrastructure along with the ongoing economic crisis has exposed the erroneous belief that the private sector can substantially complement government spending in these sectors.
Evidence from across the world provides enough proof that inequality reduction (and broad-based economic growth) is best achieved by way of government transfers and better quality public services, not by reduction in taxes. It is taxes that provide the money to fund such transfers and provide public services; countries with lower inequality tend to tax more at the margins and have far fewer exemptions.
Classical liberals argue that governments have no right over people’s incomes and that direct taxes penalize effort, and thereby reduce economic efficiency by distorting incentives. Yet, recent research from labour economics provides ample evidence to the contrary. It has been found that the disincentive effect of higher taxes on those at higher income levels is marginal enough to be irrelevant. Further, the major share of our tax revenues goes into financing capital-intensive infrastructure investments in highways, ports, airports and so on, all of which benefit the richest disproportionately more than the poor.
On a more fundamental note, it’s now acknowledged that initial conditions—family, society and other contextual factors—which are often more luck than skill or hard work, are critical in influencing outcomes. In Outliers, Malcom Gladwell has illustrated how talent is more persistence and tenacity rather than any inherent skill, and that skill and hard work entail dollops of luck. Further, minuscule differences in performance, especially in the knowledge-based professions, translate into enormous differences in incomes. In other words, all variables being equal, it is luck that decides who stands at the foot and who at the peak of the mountain.
Considering that luck holds the trump card, economists such as Hal Varian at Google and Robert H. Frank at Cornell University have favoured a model where those at the top end of the income table pay a larger marginal tax rate to discount for the extra share of luck they have enjoyed. In other words, the luckier ones subsidize those endowed with less luck.
Gulzar Natarajan is a civil servant. These are his personal views. Comments are welcome at firstname.lastname@example.org