Public Expenditure and Revenue in Times of Pandemic- Some Notes

The last couple of days is abuzz with a report from the young officers of Indian Revenue Service (IRS) over the proposed taxation measures to overcome the fiscal crisis likely to be created by the extended lockdown. The measures among other things proposed a reintroduction of the wealth tax, an inheritance tax and increased taxation beyond the current 40% for the super-rich. As expected, it has created a furore in the social media. While the government has expressed its reservations on the proposal, the right wing economic conservatives seem not to let down the opportunity of having a go at the proposals. At the same time, the government reaction is making the left led economists and politicos crying foul over the back down and seeking to project government as anti-poor and under the influence of the super-rich. In between the extreme poles, there seem to be many good suggestions that are being given a go-by. While the analysis of the proposals can be undertaken, it would be instructive to have brief overview of the possible theoretical backdrop of the public expenditure and revenue.

In the mid 19^th century, German economist Aldoph Wagner posited a law of increasing state activities. To Wagner, there was a linkage between economic growth and the relative importance of public sector and public expenditure in the economy. The growing importance of government activities was an essential feature for the emergence of the progressive state. It is worthwhile to remember the proposition of Wagner’s ideas were much before the emergence of Keynes and his articulations of government intervention in the economy that led to the birth of macroeconomics. The historical context provided the raison de etre for the public expenditure. The demand for public goods offered by the governments possessed a greater than unity income elasticity of demand. Changes in public expenditure were more an outcome or reflection of changes in economic structures underlying the country or the society. To him, in the long run, there was undisputed tendency in expansion of state activities.

To Wagner, the expansion of government activities take the shape in two forms. The first is the addition of new activities. These activities hitertho undertaken by private players now see the greater participation by the government and thus this addition is called extensive growth in public services. In contrast, there is a tendency in the government to perform the existing and new activities more efficiently. The increase in efficiency perhaps due to many reasons and expanding the scope of those activities to different sectors reflect the intensive growth in government services.

The current Indian context serves as an interesting backdrop. The government under PM Modi has increased the scope of public activities. More precisely, the expansion is through addition of new areas while increasing the efficiency of the execution of the current activities. In the Wagnerian approach Modinomics is more a reflection of intensive growth in public services. This approach has served well and more so in the current pandemic context. The schemes from Jan Dhan to Aadhar to Swacchh Bharat to Toilets for all to Ayushman Bharat to universal farm insurance are proving indispensable in the current battle against the Chinese originated virus as it creates a havoc universally. Perhaps the intensive development of public services seem to have played a role in mitigating some impact of this Wuhan pandemic crisis.

Irrespective of the mode of expansion and addition of government services, there arises the question of raising public revenues. Public revenues are majorly through taxes. In the post-colonial era, as the private sector was not in a position to ensure capital creation, the government had to step in. Moreover, it was the era where Harrod-Domar ruled partly in the belief (mistaken at that stage) that Soviet development was due to the rise of investment. Investment needed large scale resources something that could be raised through taxation. Yet the proportion of people in a position to pay taxes was small. Hence every tax new and old was sought to be levied on these sections of the people who were deemed super-rich and thus oblivious of the poverty prevailing in the country. There however reached a stage where tax avoidance was more glamorous than tax payment. This gave rise to Laffer curve. As the tax rate increases, the tax revenue increases upto a point beyond which the revenues starts to decline and at close to 100% tax rates, the tax revenue actually turns out to be zero. The proposal of IRS if accepted would result in decline in tax revenues rather than intended increase thanks to Laffer curve coming into play. Yet however, there are circumstances that allow government to raise tax rates without creating a corresponding negative vibes. To this one needs to visit an old proposition by Weisman and Peacock who presented their theory. The theory is arrived through an empirical analysis of the UK taxation system between 1890-1955.

As with any macroeconomic models, empirical foundations and behaviour do keep changing thus making those theories relevant only to particular period of time.  The Lucas paradox often spoils the intended policy effects of these theoretical applications. To Peacock and Weisman, public expenditure does not rise in linear proportion but through a series of discrete steps. A sudden war or natural disaster creates conditions for greater government intervention thus causing a spike in public expenditure. The concentration effect ensures generally it is the federal or the central government that increase their expenditure disproportionate to increase in provincial/state/local governments. The current Wuhan pandemic if left unintervened by the government and leave the solution to the private sector will create market failure. Therefore the government has to intervene and in order to sustain the economy during lockdown necessitates support of the private sector thus large spike in government expenditure. There is a need to increase expenditure and thus a higher need of revenues thus increasing the tax rates. In some ways, the net effect would be of the scenario in post-colonial period where government taxes were sought to be extracted in increasing proportions from a very narrow base. The tax rates once increased do not come back to their original levels after the abatement of the disturbance. The higher taxes and consequent higher government participation in economic and social activities becomes the new normal generating what is known as displacement effect. Furthermore, the context generally makes the people more elastic towards the tax rates. In Peacock-Wiseman’s words, there is an inspection effect that makes people respond to the higher tax needs.

The current proposal from IRS officers or at least a subset of them, is an example of the above theoretical framework. The pandemic necessitates the higher public expenditure, creates a need to generate public revenue, the tax base becomes lower thanks to drop in incomes following a shut down leading to the Hobsonian choice of extracting increasing taxes from the small base of elite and super-rich. It might have numerous unintended consequences. This is the precise reason why this proposal will and should fall through. The proposal did not arise in a vacuum but the externalities of the theoretical foundations of the proposal are overlooked. This is the defect of the proposal.