## Thursday, January 09, 2014

### Abolishing taxes

by Ajay Shah.

The BJP has started asking fundamental questions about fiscal policy. If we're willing to flirt with iconoclastic ideas, there are good foundations for two propositions:
1. It would be wise to cut total expenditure of the government to 12% of GDP.
2. There are only two sensible taxes -- income tax on individuals, and GST. All other taxes should be eliminated.
That leaves the problem of building sound tax policy and tax administration through which the income tax on individuals and the GST are setup, that yield revenue of 12% of GDP.

Let's start at expenditure. The golden age of the UK was from 1865 to 1914. In this period, the UK had price stability, the world's strongest army, good law and order, good courts, parks, clean water, a Metro system in London, and so on. They had world class public goods. Roughly speaking, the UK govenrment did all this while spending 10% of GDP. This gives us one objective benchmark: All you need, to deliver a comprehensive array of world class public goods, is 10% of GDP.

That leaves redistribution or subsidies. In the golden age of the UK, there were no subsidies. In India, we believe that we should help the poorest 20% of the population. This can be setup as a cash transfer costing 2% of GDP. If we are willing to spend 2% of GDP on delivering cash to 20% of the population, this pays for a subsidy of Rs.150 per household per day. This is an ample subsidy that will eliminate the extremities of poverty.

The government of India does a lot of things in the name of poor people. We would gain much by shutting all of them down, and replacing them by this cash transfer. The government of India does lots of things which are not public goods. We would gain much by shutting all of them down. That leaves a required expenditure outlay of 12% of GDP.

How do we obtain 12% of GDP? We need a tax system that would yield 12% of GDP. The puzzle lies in doing this at the lowest possible distortion of the economy. The distortion caused by a tax goes up sharply when the rate is raised, in proportion to the tax rate squared. An income tax rate of 20% is four times more distortionary when compared with an income tax rate of 10%. For this reason, it would make sense to have two taxes: the income tax on individuals and the GST. By having two taxes and not one, each rate can be lower.

All other taxes in India are mistakes; they impose terrible distortions and should go. These include customs duties, octroi, electricity duty, transaction taxes, stamp duty, etc. An important candidate for this bonfire of the taxes is taxation of corporations. All corporations are owned by individuals: If we just taxed individuals, we would tax all income once. The entire attempt at taxing corporations is conceptually a mistake and is worth eliminating.

We would gain a lot by getting rid of all these taxes and their commensurate tax administration capabilities. But we will need to build top quality tax policy and tax administration for the income tax for individuals and for the GST. Every individual would have to deal with exactly one tax man -- to pay income tax -- and it would be a low rate. Every firm would have to deal with exactly one tax man -- to pay the GST -- and it would be a low rate.

It is valuable to obtain income tax from a very large number of individuals in the country. This makes possible a lower tax rate. As the distortion associated with a tax goes up as the tax rate squared,
it is good to go down to a lower rate. In addition, when most adults in the country pay taxes, this improves the political economy: people who pay taxes are more careful in the expenditure programs that they ask for. In contrast, people who pay no taxes are likely to blindly support more profligacy as they are not paying for it.

For more on the tax system, see this paper by Vijay Kelkar and I.

If there is an appetite for first principles thinking, then, there is a lot of appeal in this platform: (a) A cash transfer where 2% of GDP is gifted to 20% of the population, (b) Create public goods by spending 10% of GDP, (c) Obtain 6% of GDP through a low income tax rate applied to 66% of adults, (d) Obtain 6% of GDP through a low GST rate, that is applied on 200,000 firms, (e) Remove all other taxes and (f) Remove all existing subsidies.

Every State requires tax resources. When a State has no tax base, it is down to exactly two sources of revenue: seignorage and the inflation tax. The inflation tax generates rapidly spiraling hyperinflation. When people mistrust the rupee and switch to gold or dollars or bitcoin, this hurts seignorage revenues. In history, every State that failed to build a tax capability has collapsed, and generated a social and political catastrophe.

It is easy to make fun of the BJP or AAP who are asking basic questions. There is value, however, in asking first principles questions, and in being willing to say that the emperor has no clothes. We will go far in public life in India if we are constantly willing to challenge the foundations of what is being done in public policy, for most of what is in place is based on bad thinking.

1. Great post as always.
I read somewhere that in India actual income tax payers are only 7% of population. From such a low number to go as high as 66% is politically very very hard.

I think BJP may be floating this proposal abolishing income tax as a tool to lure middle class professionals who are enamored with AAP's idealistic appeal (notwithstanding pie-in-the-sky economics)

Presently, taxation in India is already quasi consumption based, so making in fully consumption based might not be a huge leap. I am not sure if the state can achieve 12% of GDP in tax revenue or not.

Anyways, great post and please consider being an adviser to the upcoming Modi government on fiscal and macro economic policy issues.

2. If you really applied your mind on first principles, then, given your intellect, you will understand that the State itself is not required.

If you believe that the free market will fail to produce the appropriate level of public goods, even then it's obvious that the government will do worse....a 'good government' is itself a a public good.

Cheers

3. Dear Sir,
I wonder if UK of 1865-1914 era serves as a good benchmark. Their GDP was overstated on the back of their colonies' cheap input supplies and therefore, the 10% of UK GDP would actually be (perhaps) 50% of their own production.

Further, is there a basis of taking 2% of GDP as cash transfer burden?

There is no doubting yours's (and Prof. Kelkar's) wisdom on tax system though but won't it be easier to remove the personal income tax and retain the corporate income tax, given the ease of checking firms at a lower cost vis-a-vis individuals?

1. Easy is not the same as right or better or optimal.
Why should easy be a criterion at all?
What about the costs of an easy option? If they are more than the benefit of easyness whats the point?

4. Dear Mr Ajay ,illuminating article..but i must point out some factual inaccuracies that i can see(i claim to be no expert on them )..

1. In the golden Age UK had no subsidies- The existence of welfare laws /Poor laws in UK can be traced bak to 1591. Starting with the Elizabeth poor law of 1601, many extensions and ammendments were affected to these laws. The Welfare reforms of 1905 instituted old wage pensions(much like social security in america).

2. I am curious how you arrived at the relation between distortion produced and tax rates. Wont the be distortion be dependent on the the elasticity of the demand curve under consideration?

5. Finally we see some light at the end of the tunnel. Apart from the financial benefits or the lack of is the trauma associated with the myriad taxes which itself lowers the productivity of the individual and the firms -not to speak of the losses due to corruption within the system. If one puts all the coft & hard costs together alongwith the other points so clinically analyzed by Ajay Shah then it would become apparent that the current tax regimes cannot be all good.

I came across an article in the media that goes even beyond this by working out the maths for abolishing income tax altogether

6. I would say Ajay has explained a complex economic taxation in such a simplistic way. I'm bewildered if the process is so simple and goals can be achieved so easily why on earth nobody is attempting to dismantle the complex structure as it exits.

Only two aspects that needs clarity is how does revenue accrue to States and Municipalities in the Federal structure . How do we corroborate taxation rates to factor inflation and currency depreciation as they impact growth and standards.

Overall I'm impressed we must start examining things afresh with open mind to make life simpler as has been outlined by Ajay under taxation.

1. Nobody has attempted because anyone who does will run into our fantastic bureaucracy (who are the beneficiaries of various taxes) which doesn't think twice before treating our own Indians as crap but will raise hell when one of their own is caught breaking the law anywhere else. What chance does good logic have against such a bureaucracy? Our very own Humphrey Applebys....

7. Govt spending in most of the developed countries today is between 40 and 50% of GDP. Will 12% be enough for healthcare, infrastructure development, and pensions schemes? Are you suggesting that individuals should take care of expenses for healthcare and retirement?

8. Since Income Tax is paid by 3% of population it makes sense to abolish it.What about states, most taxes you have mentioned are state taxes ,how do states fund themselves.And lastly , India needs a social security system, how do we get there?
You are talking about a balanced budget, but I think India needs a mandated surplus budget.Plus one of the major reasons for inflation is financial repression.24% of bank savings are lent to government by law, so they are not saving at all.Any Idea how to get out of that trap?

1. Err.. what is the reason for your first statement? Why should the proportion of the population that pays taxes not be expanded instead? How does the low percentage imply that it needs to be abolished?

9. Since income tax compliance is so low in India, govts resort to extremely high consumption taxes. High consumption taxes hurt the poor more than the rich. Moreover since the consumption taxes are invisible (embedded in product prices) in most cases, consumers hardly know what they are shelling out to the govt and have little desire to demand for better public services for the amount of taxes they pay. This situation actually suits the corrupt, ineffective govts across the spectrum and none so far have attempted to rock the boat for the same reasons. I wonder if the new political cultures stemming from the rise of Modi and AAP can do something about it and bring in more progressive taxation. But to start with abolition of income tax altogether would be a retrograde decision.

10. It is interesting and pleasant coincidence that day before yesterday a leading newspaper also published news of another proposal for simplifying the tax structure before the parliamentary board of the same political party. This one suggests "replacing the present tax system with a single 2 per cent levy per receipt in bank accounts."

11. Great thoughts! Ajay. Let's hope May 2014 elections generates serious discussion and decisions on how best we have a fair and equitable revenue & expenditure system incorporating your thoughts and suggestions

12. Hi Ajay,

This I believe, is the proposal under consideration by BJP: http://www.arthakranti.org/proposal.

A similar-sounding proposal has been put up by an American Professor, Dr. Edgar Fiege, primarily aimed at reducing complexities of the taxation system. (http://128.118.178.162/eps/pe/papers/0506/0506011.pdf)

Here's a website devoted to it: http://thetransactiontax.org/overview/

It would be great to have an informed discussion of this proposal and your weighing in on this particular proposal (ie replacing all taxes with a basic 'transaction tax') would be much appreciated.

13. i was expecting a deeper analysis than just making numbers up. Disappointed.

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