Photo: AFP
Photo: AFP

Piketty and income tax in India

India would do well to heed Piketty's advice: Lowering inequality requires a higher income tax-to-GDP ratio

Much before his recent magnum opus, Thomas (pronounced “Thomah") Piketty was already a well-decorated economist, having won the best thesis award at the London School of Economics and the prize for the best young economist in France in 2002, and was economic adviser to a presidential candidate. But his 2013 book (first in French, and then in English in 2014) gave him superstar status. Paul Krugman said the buzz around the book reached “Beatlemania" proportions, thanks to the topicality of the Occupy Wall Street movement, and the outrage against the one-percenters. It is considered one of the watershed books on economic thinking.

The book’s main thesis is that inequality in the capitalist world has been increasing relentlessly, and this is a structural feature. Ownership of capital is skewed, and gets worse with inheritance and bequests. The returns to capital typically exceed the rate of growth of national income, making it even more concentrated, and inequality gets worse. Only a redistribution policy can addresses this. Piketty’s findings are based on an empirical analysis that uses more reliable income data from tax authorities, rather than from expenditure or income surveys. And this makes his conclusions more robust. His careful statistical analysis has made him an acknowledged authority on growth and inequality.

Of course his work relates mainly to the OECD (Organisation for Economic Co-operation and Development) world, but the lessons are surely generalizable.

What are Piketty’s lessons for India? On his recent visit, he said that India needs to address increasing inequality by increasing its tax-to-GDP (gross domestic product) ratio. Based on the Gini coefficient, India’s inequality was 0.3 in 1983, 0.35 in 2005 and 0.36 in 2012. This trend seems to confirm Piketty’s observation. Mind you, since we don’t have reliable income data, these Gini calculations use consumption data from the National Sample Survey Organisation. If anything, the consumption proxy understates the true income inequality in India. If measured as wealth inequality, which is accumulated income, Gini is probably much worse. In the absence of inheritance or wealth tax, the Piketty phenomenon of increasing concentration of wealth is very likely manifest in India too.

On top of wealth (which is the same as Piketty’s notion of capital), if you include human capital—that is, education and health achievement indicators—chances are that the respective Gini just keeps getting worse. This is not surprising since India’s public spending on health is less than one-third of China’s, as a proportion of GDP. Going from consumption to income to wealth to human capital, the final straw is social stratification, that is caste-based inequality.

There is such a thing as too much inequality. It may be in the eye of the beholder since there is no objective universal threshold of Gini. Compared with our own history, and our peers, inequality in India has been getting worse. Inequality is bad because it hurts growth. It might lead to social and political instability and civil conflict, which will harm the economy. This is an instrumental view. But surely, excessive inequality is bad for its own sake. As warned by B.R. Ambedkar in 1949, we can’t be building a democratic edifice on the principle of political equality, while social and economic inequalities continue to widen.

India’s tax-to-GDP ratio is barely 11%, well below that of the OECD and most emerging market economies. Even Brazil, whose Gini coefficient is worse than India’s, has a tax-to-GDP ratio of about 15%. To Piketty’s observation that India’s ratio is too low, the rebuttal was that there are state and local taxes that make the ratio closer to 17 or 18%. But state governments impose indirect taxes (like value added tax). Indirect taxes impinge regressively, with the poor bearing a disproportionately higher burden. Our share of direct taxes in the national exchequer crossed 50% only recently. The ideal share would be above 80%. Our tax policy seems to be veering away from this desirable direction of increasing the share of direct taxes. For instance, dividend income is tax-free in the hands of the receiver. Capital gains made after one year from sale of listed shares are tax exempt unlike any other major economy. We are possibly the only major country with this exemption.

The marginal tax rate on capital gains in most OECD countries ranges from 20% to 42%. Even Greece charges 15%. India is now contemplating extending capital gains tax exemption to venture capitalists and investors in unlisted companies too. We recently gave a income tax holiday to start-ups. All these tax giveaways come at a time when the excise duty on petrol and diesel (an indirect tax) was raised nine times in the past year. Ostensibly, the excise hike is to help meet the fiscal deficit target for this year. One doesn’t need Piketty to tell us what impact this must have had on inequality.

India would do well to heed Piketty’s advice. Lowering income and wealth inequality requires a higher income tax-to-GDP ratio. It need not mean higher tax rates. But the tax net should be cast wider. For corporate taxes, the route is simpler tax code, lower rates and very few exemptions. As we increase the share of direct taxes, we must reduce indirect tax rates. (This could be one rationale to hardcode an upper limit in the GST legislation.) To reduce intergenerational persistence of inequality we also must have inheritance taxes. Of course there are expenditure-side measures too—such as increasing spending on primary health and education (which are like public goods). It’s time to shackle the Gini.

Ajit Ranade is chief economist at Aditya Birla Group.

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