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Here’s how India’s middle class forces a Right-wing Modi govt to stay economically Left

Indian middle class’ fetish for a nanny state compels govt intervention in managing prices. This keeps both crony capitalists and voters happy.

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Why is it that 70 years after futile experiments with various brands of socialism, the collapse of communism in the early 80s, and our own modest success with market-based liberalisation in 1990-91, India has not seen a political party emerge as a champion of the economic Right? This is a question that Shekhar Gupta asked in a recent video. This merits examination.

What we have, instead, is the intriguing paradox where the Congress that introduced the liberalisation in 1990-91 is now reluctant to own and champion reforms. On the other hand, we have the BJP, which projected itself as the true champion of economic reforms at election time, doggedly pursuing the statist welfarism that the socialistic Congress was rightly pilloried for. Why is the economic Right so missing from the Indian politics?

We tend to see this lack of a vocal economic Right in Indian politics as some sort of a failure of the political parties and the politicians to know and appreciate the right economic policies.

In their classic book Why Nations Fail, Daron Acemoglu et al point out that it is politics that sets the stage for economics and not vice-versa. In other words, for the right sort of economic policies to emerge that support growth and development, you must have the right sort of politics. Politics in India is dominated by its vocal middle class, which has largely emerged after the Independence. This group is the key opinion-maker in India’s polity. Also, this class has little experience of being ruled by a centralised government but expects the government to be an omniscient nanny state that does almost everything for it except making babies.

Consider what happens when the price of onions, or tomatoes, or sugar, or petrol, or surgical stents shoots up because of scarcity or any other reason. The middle class goes on a virtual war path, clamouring for government intervention to control the price. It allows no wiggle room to market-based price signals to reallocate resources in the economy in order to balance supply and demand, and let a new market-driven price to emerge. We demand instant solutions, oblivious to their long-term implications. Politicians are only too happy to oblige since it gives them an opportunity to play God. It empowers them, and the state, at the expense of the market. Politicians, not markets, determine the price.

At the heart of market-based capitalism is the question of who decides on prices, resource allocation in the economy, jobs, output, etc. A market-based economy lets demand and supply determine prices, which in turn allocate resources and so on and so forth. Impersonal markets make these decisions in a routine manner, with government intervention limited to rare, exceptional cases where the markets fail. The whole philosophy behind market-based capitalism is to take away the discretionary power of the government from politicians and bureaucrats and invest it in impersonal markets beyond the control of any one entity. This reduces the opportunity for rent-seeking and corruption.

Instead, the whole thrust of the middle class’ fetish for a nanny state compels government intervention in managing prices, empowering the politicians and the state in the process. This serves politicians well. On the one hand, the voters are happy. On the other hand, crony capitalists who thrive on rent-seeking in sheltered domestic markets are thrilled too. They are happy to part with handsome contributions to anonymous electoral bonds in return for price setting, directly or through other means such as import barriers, favours in resource allocation, or barriers to entry in business. This creates a win-win situation for politicians, crony capitalists, and the vocal middle class; the latter capturing the bulk of the welfarism that a nanny state presides over.

Also read: Missing capital: India’s trillions-dollar wealth is chained in slums. Time to unlock it

The pampered middle class

This pampering of the middle class by a nanny state carries over to tax policies as well.

Finance Minister Nirmala Sitharaman recently slapped a 42.7 per cent tax rate on some 6,300 of India’s richest families, arguing that the super-rich can afford to pay higher taxes. These taxes are sought to be levied in order to raise resources for development. In short, the government will take a rupee from the richest and invest it in infrastructural development to promote higher economic growth. But do taxes actually work that way to promote growth, or do they, in fact, lower the aggregate amount of funds available for investment in the economy?

As Shekhar Gupta rightly pointed out in the video I referred to earlier, there is solid empirical evidence for the Laffer curve that says tax yields rise with increasing tax rates, until they peak off at some point, after which higher tax rates result in falling aggregate tax collection. In short, there is an optimum tax rate beyond which the state shouldn’t go. The rate varies but is thought to be in the 20-30 per cent range. However, this is an empirical fact. We need to actually go beyond this observed fact to look at what happens when you raise taxes for various levels of income. We do that briefly.

When you raise direct taxes for a low-income family, you force the family to consume less in order to pay more in tax. Such families don’t save or invest much. Hence, the higher rates of taxes don’t affect growth directly, except for the fact that lower consumption will result in lower aggregate demand in the future. A middle-class family in India typically saves up to 30 per cent of its income. An increase in taxes for such a family doesn’t affect consumption but lowers the savings rate to create room for more taxes. Financial savings, which are fungible with investable capital, are affected more adversely than physical savings, which in India tend to be more attractive. So, increased taxation of the middle class lowers the supply of savings that can be used for investment by entrepreneurs.

When it comes to the richest, we almost always forget that it is these people who are also among the most successful entrepreneurs in the population. They invest far more than they consume or save. In fact, their investment in capital assets for the future are orders of magnitude higher than consumption or savings. What happens when you tax them at higher rates? Obviously, consumption and savings are unaffected given their income, but their corpus of investible surpluses shrinks. That is not all.

As Adam Smith pointed out, capital surpluses saved for investment in more capital goods are the key engine of future growth. These surpluses form the “core equity” of entrepreneurs that attracts the equity of other savers to form a pool of capital available for investment. It is often referred to as promoters’ or founders’ equity, which attracts equity capital from other savers several times its value. A reasonable way to understand this is to assume that for every rupee you take away as taxes from this class, you also take away five rupees from gross capital formation in the economy. In short, the government actually lowers future growth and development by taxing this class of people. Yet, this self-defeating way of taxation remains enormously popular with the gullible middle class.

Also read: Indian elites holding back wealth tied in slums. And here’s what Modi govt can do

With the economy floundering, even at this late stage, the government should consider scrapping the capital gains tax and the dividend distribution tax. They simply shrink available surpluses with entrepreneurs and savers to invest in future growth.

Tax the escapees

Our indirect taxation of various income brackets also remains enormously sub-optimal because of the legacy of socialistic thinking. Here too, the pampered middle class gets away scot-free with lower taxes in the name of the poor when, in fact, it gets away at the expense of the poor. Consider the fact that we don’t tax food staples via GST. Ostensibly, this is done to help the poor. But in the process, about 50 per cent of the food consumed by the rich and the middle class also goes untaxed. Why should it be so? We can tax all food at a given tax rate, depending on value added, and provide a rebate to the low-income groups equal to a sum calculated to offset the tax paid by them via direct benefit transfers so that, net-net, they pay no GST on food at all. Instead, the tax burden would fall entirely on the middle- and high-income groups. My back of the envelope calculations show that the government can raise as much as 2.5-3 per cent of the GDP via moderate tax on food from the middle- and high-income groups net of the rebates that would be given to low-income groups.

We must note that the political class and the tycoons have no incentive to pursue such reforms in terms of their power-sharing and rent-seeking arrangements. Both are happy with the status quo as long as the economy chugs along at a modest growth rate without hitting an insurmountable constraint. In 1990-91, we hit an external constraint when we ran out of dollars on the external front and were forced to reform to avoid bankruptcy. In the present case, the insurmountable constraint is the lack of domestic financial savings to finance expenditure, which soaks them all up via government bonds, leaving nothing for the private sector to use to invest in capital formation. Sooner or later, this constraint will have to be addressed through reforms of the kind that the economic Right should champion.

Unfortunately, there is no such political formation in sight.

Sonali Ranade tweets @sonaliranade. Sheilja Sharma tweets @ArguingIndian. Views are personal.

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  1. Media is biggest culprit in preventing the government to allow market forces to control prices or rule of law prevail or pursuing reforms. See how media is declaring all failed businessmen as culprits and cheaters without understanding their problem. It also start playing tape of food shortage and any price rise which may not be very bad for middle class. In short media amplifies small issues facing middle class or any one so much that it requires government control at PM?CM?DM level only. It is because of media that all problems should be solved by only these three people. It has rendered all other administration useless. We do not need so much media especially TV channels.

  2. If one carefully scrutinises Modi’s record as Gujarat CM, it becomes pretty clear that his economic policies/beliefs always lay to the left. Unfortunately in the obsession of chasing him up for Godhra, most mainstream journalists completely ignored his economic record. For all his disdain of Nehru, strangely Modi’s economic beliefs completely match those of India’s first PM, rather than those of Vallabhai Patel who he professes to admire. Like Nehru, Modi believes government knows best. He believes that rather then focusing on a government’s core functions, it should get involved in running businesses, places of religious worship etc. Rather then getting rid of unnecessary laws, rules and procedures Modi thinks that all that is needed is a more government , that enforces these more effectively. Not sure if the middle class can be blamed for this as so far India has never had a government with conviction in right wing economic policies. Crony capitalists will be happy with a captive market, but not sure how it’s benefits Middle class if they have to pay higher prices and taxes to buy local goods.

  3. There is a given tax structure which any new government inherits. Based on cannons of taxation or any other empirical or theoretical foundation, it is difficult for it modify tax structure as it looks at expenses side first (including promised further subsidies etc) and works backward to match expenses with taxes. In this process, some rationalization of tax structure may take place but no major changes can happen, as total income must match projected expenses. Jaitley could have attempted overhaul of the entire architecture of budgeting including direct taxes but he wasted his time. We are a heavily taxed country and hence, can not afford to enter into free trade agreement with say ASEAN as our goods will be out priced. There is little hope from Modi 2.0 as well given how FM presented her first budget. Perhaps Modi 3.0 can take up this challenge of developing new architecture for budget where it will fix tax level at reasonable levels and budget to spend on social sector by DBT and eliminating all subsidies, introducing wealth tax, taxing agriculture income, single rate GST with refund for eligible poor etc. In short, taking Singapore as its model. It is doable if corruption is removed and inefficient administrative costs are drastically reduced with minimal government, maximum governance approach.

    • Dear Mr Barsode, you make an interesting argument that’s it’s difficult to effect change. So much so that you don’t see the govt being able to do anything wrt the taxation structure for the next 4 years. And being an understanding person that you are, you give your favorite govt 9-10 yrs for the same!!

      It’s almost like a teacher allowing a student pass by default in every year of a program even if he fails repeatedly , by saying that yes the course is indeed tough and the teacher is sure the student will do a better job 2 yrs hence!!

  4. The salaried middle class bears the harshest tax burden.I can’t believe adequate mohalla kirana shops , adequate traders , sweet/mithai shops disclose proper income. Do I see substantial self employed professional fraternity disclose actual income? Do they provide bill for services?
    Another Important area high net worth cultivators do pay they I. tax ? Has purchase of High end luxury cars stopped with source as agricultural income ?
    Last but not the least from my school days I heard of hoarding food grains ..edible oils ..Creating artificial scarcity . Did Mr Adam Smith ever discuss and predict bonanza in tax collection from increased demand .
    May it be mentioned that Indian patients paid more for same Stents et all then their European counterparts as per my knowledge. It was discussed amongst stakeholders to arrive at an acceptable solution.

    • Your response perfectly illustrates the deep distrust that the middle class has about business. This attitude is pretty widespread and, sadly, there is some truth to it. However, we are now in a loop – we seek to regulate and control businesses because we don’t trust them, and this makes it hard for them to run their business and exposes them to rent collection. The net result is that the successful businesses are ones that can navigate manage stifling rules and work hand-in-glove with rent collection. In a Darwinian way, we have created the perfect environment for increasing regulation and increasing corruption.

  5. You have identified part of the problem; however, it is less about middle class pampering and more about middle class values which percolate in all aspects of governance. Middle class is distrustful of business. The overwhelming narrative is that those who are involved in business are crooked. The solution to it has always been to increase regulation. This in turn makes it hard to do business. Getting around regulation opens the door to further rent collection. As a result, the successful businesses are the ones who are able to deal with complex rules and are complicit with rent collection. The result is a petri dish where corruption and regulation are locked in a feedback loop.

    The examples of this are all around us. A few years ago, airlines increased ticket fees and baggage charges. With the hue and cry in the media, the politicians and bureaucrats jumped in and introduced a whole set of complicated rules. Today we have airlines going broke but who remembers the little roadblocks that we create while airlines were functioning well. The hue and cry over bananas also reflect a bureaucrat taking it upon himself to right the “evils” of capitalism – never mind that the hotel was paying GST honestly and the consumer was perfectly capable of paying.

    The first step in fighting corruption should be to reduce the need for corruption so that honest businesses can succeed, and the second step is punish the guilty. Indian judiciary works in exactly the opposite way also. Our courts, reflecting the same social morality, demand increasing regulation while punishments take decades, if at all. Modi’s efforts for enforcing laws and reducing corruption are creating the dynamic that complex rules followed honestly will prevent business growth. The middle class values are often the core values of a society. As long as the middle class is unable to appreciate the hard work and the creativity of a business, we are going to be a slow moving society where legal and bureaucratic constraints prevent honest and successful businesses.

  6. 1. This article is provocative in the sense it provides an opportunity to readers like me to write on subject of tax and tax administration. 2. I begin with my views about a few misconceptions. (a) First misconception is that today’s tax regime is pro-middle class. Fact is that the government in power (irrespective of which party is in power) usually makes every effort to retain power. To retain power the government tales liberty of making appropriate changes in existing taxation as also other policies which may appear to be pro-middle class. I think such tweaking of policies is considered ‘normal’ in a democracy. (b) Second misconception is that if the government collects more tax, it is considered a progressive or pro-poor government, which is far from true. I think more than the amount of tax collected what is relevant is right, pro-poor impact of government expenditure. (c) Third misconception is that if the government earns higher tax revenue, it can spend more on welfare programmes for the poor. It rarely happens this way. Past experience tells us a different story. Though we have spent huge amounts on pro-farmer programmes, these programmes have benefited mainly the rich and politically influential farmers, who are better networked with the ruling class. Is it not true that this happens, irrespective of the party or alliance of parties in power? 3. My observation is that we have to rely on bureaucracy for everything the government does and it is here the problem lies. Fact is that no political party in power is interested in taking disciplinary action against inefficient and corrupt government officials, particularly in the middle and lower level. When government earns more tax revenue, there are Pay Commissions who promptly make recommendations to utilize a good part of higher revenue for revision of pay, allowances and benefits like the DA linked pension. 4. Tax-free agricultural income is a very effective vehicle used by politicians, government officials and of course business community to evade tax. No political party has shown courage to tax agricultural income or to close loopholes in our tax law provisions which make tax avoidance/evasion quite easy. 5. My last observation is that to minimize scope for tax evasion, particularly of indirect taxes, there should be good coordination between the Central and State governments. Unfortunately there is very little cooperation today and that leaves scope for tax evasion.

  7. I don’t think the middle class is ” pampered “. The bedrock of much that India has achieved since 1947, also a major source of income tax. One would feel tempted to say that farmers – at least the large ones with assured irrigation – are pampered, but that would be insensitive if one considers the extent and intensity of agrarian distress. 2. A party of the Right does not have a natural constituency in India, true. What comes to mind is the Swatantra party. However, it is the task of leadership, through a blend of conviction and compulsion, to do what is good for the country. The last lost / wasted decade in India is visible from outer space. MGMG many thought was a sugarcoated way of saying, We will bring 1991 2.0 and 3.0. 3. Consider power and banking, both in need of structural reform in 2014. Did anyone honestly believe UDAY, Indradhanush, Banks Board Bureau would get the job done. With these two foundational sectors troubled, the wider economy, we manufacturing, exports would all suffer. Even today the resolve to address the issue frontally is missing. 3. How can anyone possibly believe that the economy chugging along in second gear is wonderful for the average citizen, or even for the tycoons and their rent seeking politician friends. Considet the moonscape – littered with craters – corporate India has become, Anil Ambani its most potent symbol. A couple of years ago, all ten ASEAN leaders graced our Republic Day parade as Chief Guests. Today our reform starved economy lacks the self confidence to join RCEP. Idle to believe our place at the global high table is not being undermined by chronic economic underperformance. 4. How to balance, harmonise, prioritise the needs of the poor, the middle class, urban vs rural, all this is the domain of politics at the apex. How the campaign should be crafted, the message packaged is the domain of men like Prakash Kishor. As citizens and voters, we simply want the promised Achhe Din to be delivered. That will not happen without reform. And no matter how incandescent the political game aopears to be at the moment, people tend in a democracy to be a little impatient.

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