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 19th
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.
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