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Tax hike or expenditure cut?

ARVIND PANAGARIYA

 
 Most analysts agree that India must urgently bring its gigantic fiscal deficit down. The rare exceptions occur only in the context of the defence of specific, favourite expenditure proposals. For instance, Mrs Sonia Gandhi and the Left parties would sacrifice deficit reduction if the alternative is a compromise on the National Employment Guarantee scheme. Likewise, between higher expenditure on infrastructure and lower fiscal deficit, the Planning Commission deputy chairman would probably opt for the former. But in the broader macroeconomic context, virtually all agree to the necessity of deficit reduction.

The real question confronting India therefore is how precisely to bring the deficit down. Unsurprisingly, there are no magical answers. A deficit, whether it relates to the household or national budget, can be cut in only three ways: an increase in income, a cut in the expenditure or a combination of the two. In the case of the national budget, income comes from taxes so that the government must choose among higher taxes, lower expenditures or a combination of the two.

At one extreme, the option is to rely solely on expenditure cut. This has been advocated on the ground that the current tax-GDP ratio in India is about the same as the average of the tax-GDP ratios of the countries at the comparable level of per-capita income. But India’s leading public finance expert Govinda Rao has questioned the premise underlying this argument. He offers evidence demonstrating that India’s tax-GDP ratio is actually smaller than the average of the tax-GDP ratios of countries with comparable per capita GDP.

Even if one accepts the contention that the current tax-GDP ratio in India matches the average of the tax-GDP ratios in other countries with comparable per capita incomes, the conclusion that we must rely solely on expenditure reduction to correct the current deficit does not follow. For starters, we must ask whether the level of fiscal deficit in the countries with comparable per capita incomes might also not be high enough to demand action and if yes, what action do they propose. In all likelihood, a tax increase will be a part of their deficit-correction package.
 
 But importantly, even if the comparable countries actually have low or no fiscal deficits, there is nothing in economic theory that says that therefore we must keep our tax-GDP ratio at the current level and bring down the expenditure-GDP ratio to it to eliminate the deficit.

Surely, the optimal levels of infrastructure, public services and income distribution do not depend on just the per capita income. For example, geographical dispersion will influence the choice of infrastructure and public goods while egalitarianism of the society will have a bearing on its propensity for redistribution.

Add to these factors, the political economy of deficit correction. Is there a politically acceptable expenditure reduction plan that would by itself eliminate the fiscal deficit? Pigs will fly first!

At the other extreme, the view is that there is no room to cut the expenditure-GDP ratio and deficit reduction must rely solely on increased tax-GDP ratio. Unlike the “no tax increases” view, this “no expenditure reductions” view has a much larger following. This is not surprising since the constituencies that benefit from the expenditures see them as entitlements and are invariably politically powerful. Moreover, dissatisfied socialists from the 1990s within the Congress and the Left parties lean heavily in favour of a larger public sector.

Whatever the politics of the “no expenditure reductions” approach to deficit reduction, its economics is hopelessly flawed. Admittedly, increased tax-GDP ratio will have to bear much of the burden of the correction. But treating the expenditure-GDP ratio as sacred is bound to compromise the growth objective.

There are two reasons for this outcome. The first of these reasons is well known: many of the government expenditures pretend to distribute income in favour of the poor but are either wasteful or do the opposite in reality. The fertiliser and food subsidies about which I have written in detail in the past are but two such examples.
 
 Thus, the pretence regarding the fertiliser subsidy is that it benefits our poor farmers. The reality for years has been that the subsidy has gone principally to the industry. Successive administrative reform committees have shamelessly pretended as though fertiliser cannot be imported and must be produced domestically at all costs with the poor taxpayer fully covering not just its bloated costs but also a handsome profit over them!

Likewise, much of the food subsidy benefits the buyers above the poverty line and the rich farmers in Punjab, Haryana and Andhra Pradesh who receive the lucrative procurement prices. With the employment guarantee scheme (EGS) now coming to guarantee the minimum wage to virtually all, the case for food subsidy except to those whom the scheme will still fail to lift out of poverty is nonexistent. If the food subsidy remains in operation in the same magnitude as before, it can only be interpreted as the failure of the EGS.

The second reason for expenditure reduction as a part of the deficit reduction package is subtler and often goes unrecognised. The principal immediate reason for deficit reduction is that large deficits mop up private savings and thus crowd out private investment.

But if a given reduction in the deficit takes the form of an increase in the personal income-tax, the individual disposable income declines and so also individual savings. Moreover, since the marginal propensity to save rises with income, the more the tax falls on the rich, as is likely, the larger the decline in the savings.

Similarly, if taxes are raised through indirect or corporate profit taxes, they lower real incomes of individuals and profits of businesses. Both individual and business savings decline. No matter who we tax, a given deficit reduction through taxation leads to a smaller increase in private investment than would be the case if the same reduction were achieved through a reduction in the expenditure


Economic Times
AUGUST 24, 2005

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