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Kelkar II: Two cheers and a boo

July 27, 2004 14:22 IST

The Kelkar task force on fiscal responsibility and Budget management has done a great job on most fronts. In its broad sweep, Kelkar II has displayed both dynamism and clear-sightedness.

The suggestion to merge taxes on goods and services into one value-added tax on goods and services, leviable by both states and the Centre in varied proportions, shows both a commitment to simplicity and a fine political understanding of the need to devolve resources to bankrupt states.

The rationalisation of tax rates and reduction of exemptions are also in line with the need for a non-distorting and robust tax regime.

The recommendation that caught my interest, though, was the one where the committee calls for fiscal consolidation that is revenue-led.

The logic of this proposal is this: fiscal consolidation, whether it happens by raising taxes or reducing expenditure, sends contractionary impulses through the economy. Hence, it may be better to raise both taxes and expenditure -- with the former leading the latter.

In the Keynesian framework, raising government expenditure or reducing taxes tends to have a multiplier effect on GDP growth. The actual multiplier, of course, depends on the population's marginal propensity to consume.

The Kelkar committee believes that the expenditure multiplier is larger, and concludes "that the contractionary effect of cutting expenditure is larger than the contractionary effect of raising taxes". It is, thus, in favour of "placing a larger share of the required fiscal adjustment upon the growth of revenue receipts".

This is an argument in favour of raising the tax-GDP ratio through tax reforms and improved compliance even while raising expenditure to counter the contractionary impact of higher tax revenue growth.

I see two problems with this argument. One is the moral hazard: We have always put revenue reforms ahead of expenditure reforms and efficiency. Doing this in the name of counter-cyclical activity will only give the political class an argument in favour of raising more money for the exchequer instead of telling them to focus on cutting wasteful expenditure.

Second, there is a presumption that a rupee grabbed by government is somehow better than a rupee left uncollected in the hands of private individuals.

Let's look at the issue from a simplistic viewpoint. When individuals earn incomes, they can either save it or spend it. If it is taxed, the decision regarding a part of their income is taken away from them -- the government decides whether it should be saved or spent. Wisely or unwisely.

But this has some beneficial effects on the economy, thanks to the multiplier effect of government spending. Now suppose the money is left with individuals. It can have a multiplier effect to the extent it is spent and not saved.

And even if it is saved, there could be beneficial effects on the economy in the form of larger surpluses being made available for investment and lower interest rates -- which is what has been happening for the last four years. Low interest rates could trigger investment demand, which can bring forth its own GDP multiplier.

So the issue about whether the multiplier is better with higher government expenditure or lower taxes is really a non-issue because all we are talking about is whether economic activity should quicken in the short term or a little later.

On the other hand, politicians need to be told, and told today, that profligacy is not on. The real reform we need is in the quality of government spending -- not its quantity.

I am not for a moment saying that investments in infrastructure or education do not need government spending. Rather, I would like to underline the importance of raising money only for specific purposes through specific means.

It is utterly counter-productive, especially in our political milieu of irresponsible populism, to raise revenues in India without being clear about why they are being raised, where they are going to be spent, and how effectively.

Raising huge amounts for the exchequer, even in the name of tax reforms, is a moral hazard we cannot afford. In any event, revenues per se are not important for the government. Its prime task is to ensure that the economy's topline is growing -- and that means making sure that GDP is growing fast enough to keep lifting more people out of poverty. This may or may not need resources.

Cutting red tape, instituting e-governance, and freeing businesses from the inspector raj don't need more taxes. It needs political will. Feeding and clothing the poor does need resources, but what matters is whether the money actually ends up feeding or clothing the poor or is swallowed up by a corrupt political system. Again, changing this needs more political will. The resources can follow.

This is not an argument against what Kelkar & Co have suggested by way of reforms, but sometimes it is necessary to repeat the obvious: one should never put the revenue cart before the expenditure horse.

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R Jagannathan