Not only is the country’s tax base small, it is also difficult to raise tax rates too much without reducing compliance
Ila Patnaik writes…
Rate cuts by the Reserve Bank of India (RBI) may not find transmission into lower interest rates in the Indian economy if election promises of large cash transfer programmes are kept. Fears of large government spending without any clear plans to raise tax revenue or cut other expenditure can increase economic fragility as well as create expectations that India will move away from the path of fiscal consolidation. This would mean government can only borrow at higher interest rates. Higher cost of capital would mean lesser private investment.
Election promises of both leading political parties involve larger government spending. Both the Bharatiya Janata Party (BJP) and the Congress have made promises regarding cash transfers in their election manifestos. India’s fiscal deficit currently stands at 3.4% of gross domestic product (GDP). Even this is an underestimate as not all expenditure was shown in this year and not all borrowing was shown to be explicit borrowing of the Central government in the last budget. Both parties remain quiet on how they plan to fund the additional expenditure; the two paths to not borrowing more are either to tax more or to cut expenditure.
The government has already launched the Pradhan Mantri Kisan Samman Nidhi Yojana for cash transfers to marginal or poor farmers who own land up to two hectares. The manifesto promised to increase the scope of PM-Kisan scheme to all farmers in the country. In addition, the BJP manifesto promises a pension scheme for all small and marginal farmers in the country. Short-term new agriculture loans up to Rs 1 lakh at zero per cent interest rate would be made available. Even beyond the manifesto, there are promises for collateral free loans of Rs 50 lakh to traders and pensions for shopkeepers.
The Congress has promised farm loan waivers, one crore jobs, National Rural Employment Guarantee Act (NREGA) days to increase from 100 to 150, and the Nyuntam Aay Yojana (NYAY) to provide Rs 72,000 a year to the 20% poorest families in the country. Health expenditure would be doubled to 3% of GDP, and so on.
If all these election promises are to be kept, Central government expenditure would increase by around 3% of GDP. One proposal is to tax the rich more. But who is rich in India? The notion of rich is, of course, relative. Households who earn Rs 1 lakh per month in India are rich by Indian standards as only about 0.3% of the population earns more than Rs 12 lakh a year. 99.7% of households in India earn less than Rs 1 lakh per month.
Taxing 0.3% of households to distribute to the remaining looks very hard. So perhaps the top 5% should be taxed? But 95% of households earn less than Rs 50,000 per month (or ~6 lakh a year). Eighty per cent of households earn less than Rs 3 lakh a year or Rs 25,000 per month. This is hardly the section that is “rich” and should be taxed to pay for the poor.
At best, raising taxes for redistributing income from rich to poor households would involve taxing about 5% households who earn more than Rs 50,000 per month and transferring money to the poor. This has limited possibilities. Not only is it difficult to tax the middle class politically, even the amount of revenue that can be raised without pushing rates too high and taxing away even 50% of their income, or almost Rs 25,000 per month away from them, will not raise revenues adequately.
Not only is the tax base small, it is also difficult to raise tax rates too much without reducing compliance. Wealth tax, or taxing the super-rich in developing countries, has usually ended up in capital flight without raising revenues.
The other alternative is to cut expenditure. Considering that interest payments, salaries and subsidies are difficult to cut, there are no clear plans outlined by either party on what will be cut. Usually this means, as it has in the past, that capital spending will be reduced.
In all probability, large cash transfer programmes mean large fiscal deficits, upward pressure on interest rates and moving away from fiscal targets. If all that is promised materialises, India will, unfortunately, almost certainly, head towards a fiscal crisis.
Ila Patnaik is an economist and a professor at the National Institute of Public Finance and Policy
Published in The Hindustan Times