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Business News/ Opinion / Online Views/  Tax policy and the size of the government

Tax policy and the size of the government

The directional size of the govt currently needs to go up, with or without the need to close the fiscal deficit

In an inflationary environment, the scope to raise consumption taxes (which raise prices across the board) is low. Photo: Priyanka Parashar/Mint (Priyanka Parashar/Mint)Premium
In an inflationary environment, the scope to raise consumption taxes (which raise prices across the board) is low. Photo: Priyanka Parashar/Mint
(Priyanka Parashar/Mint)

As we saw earlier, if we admit the possibility that the redistributive cash transfers implied by the National Rural Employment Guarantee Act (NREGA) are an OK policy by themselves, we are left with the corollary possibility that the fiscal deficit is a result of not raising tax rates, rather than the spending itself. To paraphrase the 19th century British economist Alfred Marshall, asking whether spending or taxes are responsible for the deficit is a bit like asking which blade of the scissor does the cutting. However, tax policy is the sine qua non of the political and commercial legitimacy of the state, and is hence a question as much of political philosophy as of economics. Ethical judgements are indispensable and I’m positing the view that the increased government spending for redistribution is perhaps ethical, so that what is truly ‘unethical’ (or unsustainable, coming back to the more grounded economics of the fiscal deficit) is the lack of corresponding increase in taxes.

This is where finance minister P. Chidambaram’s exhortation to ‘share the burden’ with increased taxes is important. Predictably, he was hounded for first having emptied the treasury and then calling for higher taxes. But the higher taxes are unavoidable. If so, what could those taxes be?

The economics literature on public finance and taxation is vast and varied. There seem to be some broad agreements on the design of optimal tax policy, though. Broad base, low rate. Tax consumption, or income, if you must. Avoid taxing capital. Definitely don’t tax corporate income. Tax wealth in a lump-sum manner if you wish to solve for endowment failures. Tax luxury transactions. The arguments are many and hard to summarize, but Scott Sumner’s post over at the Economist makes a cogent case for the mainstream theoretical position.

Note that consumption taxes, which everyone seems to love when presented as VAT/GST (value added tax/goods and services tax), are basically the same as the sales and excise taxes decried as the taxes that all of us, including the domestic help, pay to ‘feed the beast’. The big benefit is the simplified regime (which will tremendously slash supply chain costs across the country, for one). Consumption taxes are also great at acting as automatic fiscal stabilizers—though the farm loan waivers of 2008 are invoked very often, by far the bigger fiscal action taken that year to keep private consumption and production up in the face of a global recession was to lower sales and excise taxes substantially.

Some have argued that consumption taxes are regressive (especially when thought of as a ‘flat tax’), as the poor consume a higher proportion of their income than the rich. Some combination of a highly progressive wage income tax and luxury taxes should fix that. Capital income taxes are slightly more tricky, with the usual argument that they are double taxation being counter-balanced by arguments about equitable taxation between capital and labour. A more original argument comes from Earl Thompson, the highly original UCLA economist, who argued that the biggest beneficiaries of national defence are capital owners, and capital taxes thus exist to solve for the disproportionate consumption of that particular public good.

In general, though, the broad thrust for tax policy remains clear. Get to the GST regime faster. Do all you can to eliminate corporate income tax. Get the income taxes right—broad-based, and hopefully low.

The implications of this for India are interesting. For one, a declining corporate tax would mean that all talk about eliminating personal income tax should be consigned to the bin. Secondly, a GST, while hugely beneficial in many ways, will not necessarily boost revenue by much as we already pay a bunch of sales and excise taxes. Big reforms that would be needed are the inclusion of farmer incomes in the income tax net and a reduction in the income bracket that qualifies for 0% tax. Most of the public finance ‘budget’ analysis in India around personal income taxes is urban, elitist, ill-informed and simply backwards. While the need to include farmers into the income tax fold is widely recognised, increases in the minimum tax bracket are celebrated. Leaving out corporate profits, depreciation, indirect taxes and transfers etc. from the GDP to arrive at personal income, we get a figure of around 70 trillion, earned by the 390 million people employed in the labour force in India. Of this, agriculture income accounts for nearly 14 trillion (16% of GDP), earned by some 225 million people employed in agriculture. The remaining 165 million earn 56 trillion. Even if we assume that the urban labour force earns the same on average as rural non-farmers (fishermen, forestry product traders)—a fairly generous assumption likely to underestimate urban income -- we get the mean urban income as 3.4 lakh per annum. The median is probably closer to Rs2.5-Rs3 lakh. Given the personal income tax slabs in India and the special concessions and deductions available, which push the zero-tax income to about 3 lakh, this means that more than 50% of the urban labour force pays no income taxes.

And that figure of tax-to-GDP ratio—17%—is itself worth mentioning. It’s very low on the global scale, and among the lowest in emerging countries. While we may like to fret about our huge and inefficient government, we are among the least government-supplied states in the world, whether it’s per-capita policemen, per-capita armed forces, per-capita diplomatic staff etc. If we want a proliferation of private schools, private hospitals, etc. then we have to recognise that these entail significant redistribution demands, which again raises the need for tax and spending. India is an under-taxed state, our government is under-funded. Its inefficiency in collecting even the revenue that it’s entitled to is glaring, with obnoxious last-ditch attempts like delaying deserved refunds on tax paid earlier.

Of course, all this makes the inefficiency of the state and the dabbling in unnecessary enterprises all the more palpable. But what that also means is that at current margins, this is not the time to starve the beast. Lowering taxes to lower spending does not guarantee that wasteful spending will be reduced. If anything, an inefficient and perverse beast is likely to cut the justified spending just as much—if not more—as the wasteful spending.

Improving the public-choice performance of the government is an activity that goes hand in hand with getting the size of the government right, and does not need to force it this way or that. The directional size of the Indian government currently needs to go up, with or without the need to close the fiscal deficit. In an inflationary environment, the scope to raise consumption taxes (which raise prices across the board) is low. What that should mean is more income taxes and luxury taxes. I fear that what it would mean, unfortunately, is higher corporate taxes.

The writer is a London-based consultant. This is the fourth of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment.

“These are the author’s personal views."

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Published: 19 Oct 2012, 12:32 PM IST
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