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.
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.
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.