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Mr Chidambaram: go for gold

Last updated on: June 30, 2004 12:40 IST

It is eerie, but the tax policy choices that Finance Minister Mr P Chidambaram (PC) faces today are near identical to his dream Budget of 1997. 
 
At that time, both the hard "human-face" economists, and the soft budget-constraint Left, advocated that personal income tax rates were "correct", should remain stable, and that attempts to decrease tax rates would lead to a severe decline in tax revenue. 
 
Plus it would be unseemly for the rich paying anything less than a 40 per cent marginal tax rate. They laughed at the Laffer curve hypothesis saying that anything worked out on the back of a napkin was not rigorous enough, certainly not for the fiscal fundamentalists at MIT. 
 
The Laffer back of the napkin thesis is that the only method of increasing tax revenues is by increasing compliance, and the only method for increasing compliance is by cutting tax rates to "reasonable" levels. 
 
The policy choices for PC are basically three: first, do nothing. Second, pursue direct tax policy reforms as outlined in the Kelkar Task Force (KTF) report; and third, go beyond the KTF recommendations on personal income tax rates. 
 
The argument for PC doing nothing: after all, the government has just entered office, a quarter of the year is over, and why not take time to prepare the Budget in February 2005. Several reasons why the do-nothing advice borders on the ridiculous. 
 
First, its logic is not compelling. Do nothing implies that there are no issues to be addressed -- that, especially given the demands of constructing a human face, is not true. Nor is the situation akin to that of a cancer patient -- we have had high (consolidated) fiscal deficits for 25 years, so what is the hurry? According to that logic, why do reforms in February 2005 either. 
 
Second, the early days of a government are likely to be the most effective; this is time when expectations have not built up, lobbyists have not assembled a game plan, and PC's co-ministers have not had time to find out where the leakages can be turned into a flood (of revenue for them!). 
 
Third, recall that if PC had heeded this nonsensical do-nothing advice in 1997, he would not have been able to usher in a radical change in India's tax policy (Congress leader Kesri pulled the plug in end-March 1997). 
 
Unlike 1997, there is no politician waiting to pull the plug today, so PC can theoretically play it safe. But the world (thankfully) has changed for all of us. There is someone else who has both her hands on the plug.  The investor, both domestic and foreign.

The Indian stock market has performed catastrophically since the first signs emerged about the NDA government not being returned to power. The rest of the emerging markets are down 8 per cent (since April 26), while we are down almost three times that amount -- approximately 24 per cent. But no real money has pulled out as yet.  Why? Because investors are waiting to see if the government delivers a peaceful do-nothing Budget. Which will be a signal that this government is top-heavy in economic brains but with feet firmly deposited in the cement (the navratnas?) of ancien regimes
 
If do-nothing, or voodoo economics is the norm (as suggested by large elements of the Common Minimum Programme), the consequences are predictable, and will be considerably worse than Mr Kesri's summer of 1997. 
 
In a pre-Budget consultation with economists, Mr Chidambaram asked for big ideas. He already had one such idea in 1997; the same idea is even more relevant, and potent, today. The Budget is primarily about tax policy, the rest can be left to the deans of the CMP. 
 
The other parts of government have to come to the finance ministry, and the ministry has to come to the people, for the money. And we, as history has shown, are a stingy lot. We understate incomes, we fail to file tax returns. 
 
Only one in five today files a return; together with understatement, the total revenue loss (with full compliance as a benchmark) is a staggering Rs 2,50,000 crore (Rs 2,500 billion). The gap will not, cannot, be filled with business as usual. The only chance of filling the gap is via lower tax rates. 
 
The KTF moves in that direction. It recommends a new simplified tax structure: the first lakh of income is exempted, Rs 200,000 to Rs 400,000 is taxed at 20 per cent and incomes greater than Rs 400,000 retain the original tax rate of 30 per cent. 
 
The average tax rate is expected to decline from 17 to about 14 per cent -- average tax revenue to (initially) decline by about 20 per cent. The KTF hopes to make up the tax loss by corporate tax reforms. 
 
The KTF correctly believes (not hope) that the personal income tax loss will eventually be more than made up by increased compliance. It has got history on its side. In 1997, tax rates were reduced for all tax payers; the effective tax rate declined from 22 to 16.3 per cent. 
 
Economists did a quick math and came to the conclusion that revenues would be 25 per cent lower. Cannot be done, should not do it, don't be stupid were some of the barbs. Perhaps Mr Chidambaram's inner voice ruled because he went ahead and just did it. 
 
A year later, the results of the live Chidambaram-Laffer experiment were out. Instead of declining by 25 per cent, tax revenues stayed constant, thanks to a large increase in compliance -- from 5.5 million taxpayers the year before to 6.8 million in 1997-98. 
 
Over the next six years, overall compliance increased by 50 per cent -- from 11.9 of the taxpayer population to 18.2 per cent (all numbers for those with incomes above Rs 100,000). 
 
The KTF compliance increase is expected to be smaller; compliance is likely to be up by only 25 per cent, not 50 per cent. Why? Most likely because it only marginally cuts the effective rate for those (>Rs 10 lakh) who contribute more than a third of the total revenue, and constitute only 1 per cent of all taxpayers. 
 
In the year 2002-03, this group had 70,000 taxpayers from a population of approximately 350,000. It is unlikely that the KTF policy of no reduction in tax rates for the rich will get the rich "out to pay". 
 
An alternate proposal, but one in the same spirit as the KTF, and more in the spirit of PC 1997, is to be bolder towards the idea of catching mice. The proposal is to tax Rs 100,000 - Rs 400,000 at an 18 per cent rate, and > Rs 4 lakh at a 25 per cent rate. 
 
With this scheme, the overall tax rate is reduced by 5 percentage points to 12.1. Which means, if PC's history repeats itself, there might be little decline in revenues the first year, and considerable improvement a few years hence. 
 
Which of the three choices is PC going to make? The economically and politically correct choice is the one he made in 1997 and should make in 2004. He should not listen to the do-nothing alchemists who believe that the route to higher tax revenues is either by raising tax rates, or keeping them the same. These recommendations are "Laffable". 
 
Instead, he should listen to his inner voice, circa 1997. Come Budget day, he has a choice -- either be a thin cat waiting to catch big mice or be a fat cat which is able to catch fat and thin mice.

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Surjit S Bhalla