Grow and Earn

THE ONLY THING worse for economic well-being than a tax and spend policy is a spend and tax policy. India is increasingly falling into the second category, particularly at the level of state governments. The prime minister has spoken out against a culture of freebies. At the level of the Union government, there has been a reasonable degree of fiscal prudence. However, in states, especially in the run-up to elections, there has been a proliferation of spending commitments, most notably in the form of cash transfers to targeted groups. While these may bring electoral success, they can return to bite.

In a tax and spend mode, the government first mobilises revenue and then allocates its spending. At least, there is an element of planning. By announcing spending first, there is always an element of the ad hoc about how to finance it. A prime example is the recent suggestion of a group of ministers (state finance ministers) to add a fifth slab to the Goods and Services Tax (GST) at a rate of 35 per cent. No doubt the motivation is to shore up state finances as expenditure commitments rise.

There is a politically attractive façade around the proposal. The proposed new rate will apply to sin products such as tobacco products, alcohol, sugary drinks, or ‘luxury’ items, such as readymade garments which cost more than `10,000. People who consume these should and can pay more. But it’s poor economics.

According to every study and most practical experiences, a single rate GST is the most efficient and revenue maximising. In 2017, when GST was being implemented in India, there was a proposal of a revenue-neutral rate of 14 per cent or thereabouts. But it was inevitably caught up in the old socialist reasoning: Should milk and Mercedes be taxed at the same rate? In the end, a compromise was reached on four rates (5 per cent, 12 per cent, 18 per cent and 28 per cent) along with exemptions (petroleum products). This complicates the entire structure (including the system of input credits), increases administrative costs, leaves the system vulnerable to unproductive rent-seeking as lobbies try and get goods and services moved from one slab to another and delivers less revenue than a simple system.

The hope then was that as the system evolved, the tax slabs would be reduced. The pressure seems in the opposite direction.

By announcing spending first, there is always an element of the ad hoc about how to finance it. A prime example is the recent suggestion of state finance ministers to add a fifth slab to GST at a rate of 35 per cent

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The concept of progressivity is already embedded in the direct tax system. Those individuals and firms that earn more pay a greater amount in taxes. For individuals, cesses and surcharges included, the top rate is already approaching 40 per cent. Globally, it is not used in the design of indirect tax systems. The fact is that while certain goods may be purchased by people with a higher income, there is an entire economy around them. There are multipliers in terms of growth and jobs. There are people who earn modest or decent livelihoods from the ‘luxury’ spending of others. Or ‘sin’ spending. A high rate of GST isn’t just a burden on the buyer but penalises the entire ecosystem around the seller.

Also, some of the proposals smell of the Licence Raj era and will likely lead to distortions that were the defining feature of that time. Dividing readymade garments into three categories, those which cost up to `1,500, those that cost between `1,500 and `10,000, and those that cost above `10,000, each to be taxed at a different rate, brings back memories of the heavy hand of bureaucracy. How is an officer to judge what constitutes a cheap, reasonable and expensive price? Markets do that. If the gate is opened with readymade garments, there is potential to divide several goods and services into arbitrary categories. Sellers will respond by playing with prices. There will be black markets for ‘expensive’ garments. Ultimately, revenue will fall, not rise.

Instead of this slippery slope, governments should eschew spend and tax and tax and spend, and move to grow and earn. Revenue can be mobilised either by raising tax rates on the existing piece or letting the pie grow with existing rates. Or even better, with lower rates. States should focus on reforms that will drive investment and production. Revenue will follow.

About The Author

Dhiraj Nayyar

Dhiraj Nayyar is chief economist, Vedanta Ltd, and the author of Modi and Markets: Arguments for Transformation

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