Column: Focus on GST and DTC first

Jan 17 2013, 03:09 IST
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SummarySince the rich save more, a higher tax on them will have implications in terms of overall savings levels.

address India’s fiscal woes.

While there is little disagreement about the need for focusing on revenue-augmenting policies, the proposal of taxing the super-rich requires the following consideration.

First, the proposal implies that we are operating at a point below the revenue-maximising point on the Laffer curve. Research by economists such as Martin Feldstein suggests that this may not be necessarily bad. As tax rate rises, the ‘deadweight loss’ to the economy rises, so that as the rate gets close to the revenue-maximising point, the loss to the economy exceeds the gain in revenue. Therefore, policymakers should strive to set tax rates at the growth-maximising point rather than at a revenue-maximising point. This effectively means that tax rates should be set to generate enough revenue to finance the growth-maximising level of government. So, the Rahn curve, or the spending version of the Laffer curve, should be a better guide to inform policymaking in this regard.

Second, we need to be mindful of the adverse supply shock that a high tax rate on high earners could create. The average propensity to save is usually high for high-income individuals. So, a higher tax burden on the rich is likely to decrease the aggregate saving and investment rate in the economy, leading to a reduction in aggregate output and employment in the economy. At a time when growth in national output is falling, and business sentiments are low, implementing the above proposal in the upcoming Budget could further depress the economy.

Third, the relationship between tax rates and tax revenues might not be linear. It will be important to look at the effect of a rise in the peak tax rate on the taxable income of the economy. A higher marginal tax rate may not necessarily generate additional revenue, particularly if people respond in ways that result in less taxable income. There are several possibilities of how the rich might behave when their taxes rise. International evidence suggests that a higher peak tax rate could reduce work effort and business creation; a larger share of the earnings could be taken in forms that are taxed less; and money (and talent) may move offshore to lower tax jurisdictions. All these could lead to large negative economic effects, which may outweigh the positive arithmetic effect.

Fourth, in absence of robust compliance machinery, higher taxes on the rich are unlikely to get translated into higher revenues for the government. With the poor

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