Why the BJP should reject a bad idea

Quixotic tax ideas have a long history. The kings of medieval Europe thought they could increase their revenues by taxing people according to the number of windows to their homes. The idea was that richer folk with bigger homes would automatically pay higher taxes. It was not to be. Smart citizens preferred to build large houses with few windows. These architectural oddities can still be seen in the older parts of many European towns.

This cautionary tale of blank walls should have current resonance. Some leaders of the Bharatiya Janata Party seem to be fascinated by a similarly quixotic proposal to replace the existing tax system with a single tax on all domestic transactions done through the banking system.

It is not yet clear whether the party that hopes to form the next government in New Delhi endorses this idea, but here are four reasons why it should not.

First, such a tax would be regressive. The usual assumption in public finance is that direct taxes are progressive while indirect taxes are regressive. A regressive tax imposes a higher burden on the poor relative to their ability to pay. A good tax system tries to be progressive. One of the significant achievements of tax reforms over the past two decades has been to increase the proportion of direct taxes in government revenues even as tax rates were reduced. The transaction tax is an indirect tax that will take us in the opposite direction. It will make the Indian tax system more iniquitous.

Second, economists Peter Diamond and James Mirrlees have shown in a landmark paper on the design of an optimal tax system that taxes should not be imposed on intermediate goods or inputs. Their two-part paper was published in the American Economic Review in 1971. Their celebrated production efficiency theorem was constrained by specific assumptions, but the broad lesson can be adapted to the real world. The subsequent movement worldwide towards value-added taxes that allow producers to reclaim taxes paid on inputs is at least partly because of the insights from Diamond and Mirrlees. By taxing inputs, a transactions tax will reduce economic efficiency.

Third, such a tax will have a cascading effect, as each transaction in the production process will be taxed. It is not clear what this will mean for inflation but it could have effects on the production structure of the Indian economy. The tax will likely create artificial incentives for vertical integration of production. In other words, companies will try to manage the entire value chain within their own factories. This flies in the face of the very idea of an efficient division of labour based on modern supply chains that has served the world so well over the past two decades.

Fourth, a transaction tax will undermine Indian federalism. The constitution does not allow states to collect taxes on financial transactions. That is the prerogative of the government in New Delhi. It is well known that the states continue to be worried about the loss of fiscal autonomy after the introduction of the goods and services tax (GST), which is otherwise an excellent idea. What is now proposed is to abolish all taxes that the states can collect. It will be argued that the Union government can pass on some of the tax collected through the Finance Commission framework, but this would still mean that states—as well as the villages, towns and cities on the third rung of administration—have no independent source of tax.

These are just four of the most obvious reasons why the idea of replacing the existing tax system with a single tax on economic transactions is a bad one. It will violate two key characteristics of a good tax system—equity and efficiency. It will create economic distortions, hurt employment generation and undermine fiscal federalism. It will create incentives for people to transact in cash rather than through the banking system.

There is much that the next government needs to do on the tax front.

The direct taxes code should be pushed through so that we have lower tax rates as well as minimal exemptions. GST has been delayed far too long because of political bargaining between the states and New Delhi. The tax base has to be increased because too few people pay income tax in India. Tax administration should have less of harassment. There are several problems to each of these initiatives but there is no reason to doubt their underlying economic logic.

It is mildly distressing that the quixotic idea of a single transactions tax is attracting the attention of influential political leaders, albeit only a handful of them. There has also been a lot of excited chatter on the Internet about its suitability for India. The excitement will not convert a bad idea into a good one.

So, as they say, a little economic knowledge can be a dangerous thing.

Is the single transactions tax a bad idea? Tell us at views@livemint.com