Free trade across borders cannot be achieved without competition between governments
It is now accepted almost across the board that the goods and services tax (GST) moved in Parliament last week will give a much-needed boost to the Indian economy. In fact, it is said to be the single-most important reform since 1991 that could substantially increase India’s growth.
This belief is wrong and it is not because the benefits of a single market and low, simple taxes are not real. The world economy saw the greatest levels of prosperity under the classical gold standard when a single currency and absence of trade barriers allowed the free flow of resources internationally. Thus, there is a strong case in favor of a single international market, not just limited to India.
The problem instead lies in the means to achieve such a unified, efficient market. Supporters of GST are convinced of its merits merely because of existing trade barriers between states. If the Central government were to take charge of the economy, they say, such barriers could finally be torn down for good. Their anger against trade barriers is understandable, but it is misguided.
For one, in cases where inter-state trade barriers are the product of interest group pressure, these can be overcome by free trade lobbyists more easily at the state level than the centre. Assuming the Central government will be aloof from the pressure exerted by interest groups is merely wishful thinking.
Two, when trade barriers result from states’ urge to boost revenues, competition between states can tear them down. This is since businesses and goods move to states that offer better conditions.
West Bengal has torn down border controls to prevent rent-seeking and facilitate the free entry of goods. Even a backward state like Bihar in 2009 introduced a flat tax scheme and reduced tax scrutiny to help small businesses, which in turn led to a boost in voluntary filings. Even earlier, many states competed by reducing sales tax (so-called rate war) before the value-added tax (VAT) was imposed to harmonize rates across states.
This brings us to probably the most inane argument in favor of GST: multiple rates across states increase compliance costs and does harm to business. For sure lower rates, even when multiple rates exist across states, are more attractive for business than a higher uniform rate across the country?
India can learn much from the US on the potential of inter-state competition. Following a rich tradition of struggle for states’ rights, American states have found their tax policy to be an efficient tool to attract labor and capital. Between 1995 and 2010, over $2 trillion worth of capital moved between state borders in the US, as documented by Travis H. Brown in How Money Walks. There is also a large amount of statistical data showing, among other things, how high-tax states like California have lost labor and capital to low-tax ones like Texas and Florida.
The formation of the European Union (EU), on the other hand, was supposed to establish a common market across Europe. But subsequent events confirmed what any federalist would have expected. For instance, the EU imposed a minimum value-added tax rate of 15% across member states to achieve tax harmony, thus shielding high tax countries like Germany and France from low tax competitors like Switzerland and Luxembourg. Political lobbying, not economic efficiency, drove EU tax policy based on central control.
The outflow of labor and capital disciplines bad governments and pushes them to adopt better domestic policies, leading to higher overall growth. Even if losing states refuse to reform, competing states serve as an outlet for capital and labor that would otherwise be utilized inefficiently in laggard states.
In India, the migration of labor from backward states like Bihar to more prosperous states, and the flow of private investment into a handful of states like Tamil Nadu and Maharashtra with relatively better business conditions is good evidence of the trend.
The economic advantages of a single market are worth emulating, but centralized power is not the smartest way to go about achieving it. Competition is good for the consumer; and this is no less true of taxes, where only inter-state competition—not benevolence from the centre—will benefit citizens.
Natural Order runs every Monday, with a libertarian take on the world of economics and finance.