Why Higher Tax Rates May Make Sense

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Photo by Kelly Sikkerna on Unsplash


Early this month, Nirmala Sitharaman, India’s Finance Minister presented Union Budget in the Parliament and soon after, media was abuzz with concerns around hike in effective tax rate for the super-rich class of India which has shot up to as much as 43% for those who earn more than INR 5 crores a year. The primary concern were two-fold: 1) Is increasing the tax rate the only viable way to shore up tax revenues? 2) Would a higher tax rate actually lead to higher tax revenues or on the contrary lead to increasing instances of tax evasion?

Revenue Neutrality Compromise

To understand the depth of both these questions it is important to understand the right context around Indian taxation regime. In India, direct taxes (income-based) constituted 52% of the total tax collection in 2016–17 which is marginally higher than the indirect tax collections that include GST and customs duty. Standard economics prescribes that indirect taxes are regressive because both the rich and the poor have to equivalently share the burden of tax for their consumption basket. From a social welfare perspective, this is not a desirable outcome. Ideally, policymakers would want individuals with higher willingness to pay to share a higher burden of the tax base of the country. It is important to underline here that the successive lowering of GST rates in 2018–19 will dampen the revenue collections from indirect taxes. To provide a context here, while the budgeted estimate of collections of GST tax revenues was INR 7.43 lakh crore for 2018–19, what has come underway as per the revised estimates shown in the budget is a whooping 14% lower figure of INR 6.43 lakh crore. This deficit has to be compensated from an alternate channel. And, thus hiking the direct tax rate is less a matter of choice and more a matter of compulsion unlike what many experts may want to believe. And therefore, bringing a 3% surcharge for income exceeding 2 crores and 7% surcharge for income exceeding 5 crores is a desperate attempt by the government to manage the revenue shortfall. No other short-term measure can prove as effective.

Tax Avoidance by FPIs

Coming to the larger question around tax evasion or avoidance, standard economic theory posits that a moderate tax rate is often the optimal strategy to accrue high tax revenues. Extreme tax rates — lower and higher tend to have worse outcomes. Laffer’s simplistic prescription to solve this tax dilemma by setting a middle ground of tax rates should bring smiles on the faces of corporate honchos, and it has. No wonder, Laffer was recently coronated by Trump with the Presidential Medal of Freedom — the highest civilian honor of USA. Although Laffer is certainly right in proposing a conservative stance for taxation, most economists often miss out on two key points: 1) would a marginally higher tax improve the status quo of tax collections — comparison with status quo is critical here and 2) does tax evasion/avoidance become a problem only when marginal higher tax rate is imposed or is it already an area of concern in the economy. In both cases, if you look closely, the comparison with status quo is essential to be able to comment on the benefits of a tax rate hike. Even with a reasonable tax regime concurrently, we witness creative tax avoidance strategies by firms. To provide an example here — several foreign portfolio investors in India are not registered as a company or an LLP firm but pay their taxes through a taxation channel called Association of Persons (AOPs). Often several FPIs form trusts which are also treated as AOPs and attract lower tax rates. From 2013–14 to 2017–18, the number of tax returns filed by AOPs has practically doubled from 1.01 lakhs to 2.07 lakhs. In the same timeline, the number of taxpaying trusts has also spiked up by more than 25%. The intent of the government to raise surcharge is aimed at bringing these FPIs to tax books. Tax avoidance, especially by FPIs, who route this money to their home country does not bode well for the country anyway.

Normative Dilemma

The third and larger point is whether it is ethically justified to tax the rich more in India today. And, whether government is the right entity to channelize surplus tax collections slated for later redistribution and driving equitable growth in the economy. Oxfam published a report last year ‘Reward Work, Not Wealth’ which highlighted that the richest 1% in India amassed 73% of the wealth generated in the country last year while the bottom 67% witnessed their wealth crawl up by 1%. This a tremendous divide and if anything, the statistic is a loud call to action that the wealth distribution pattern in India is broken and needs immediate repair. If the larger concern is that redistribution policies of government agencies are plagued with humongous leakages, then prescriptions proposed should aim at minimizing these leakages rather than raising demand for blanket tax rate cuts. India now suffers from a billionaire syndrome where there has been a boom in the number of home grown billionaires coupled with massive class divide elucidating the fact that wealth generated at the top is not being trickled down to those working tirelessly at the bottom of the pyramid. Only the government, by its design, is best placed to set this imbalance right. In fact, if we have a broad consensus that the inequality divide which we saw above is indeed worrying, then direct tax rate hikes may just be one of the many solutions to better the situation. Other set of prescriptions will include limiting the pay out to top level executives as a ratio of the lowest wages paid out to employees in the firm, limiting dividend pay out ratios and halting paying bonuses beyond a certain threshold until all employees in the company have received a dignified living wage.


The last few lines from the famous documentary ‘Inside Job’ are worth reflecting here. They make a lot of sense even in the Indian context.

“For decades the American financial system was stable and safe. But then something changed. The financial industry turned its back on society, corrupted our political system and plunged the world economy into crisis. At enormous cost, we’ve avoided disaster and are recovering. But the men and institutions that caused the crisis are still in power and that needs to change. They will tell us that we need them and that what they do is too complicated for us to understand. They will tell us it won’t happen again. They will spend billions fighting reforms. It won’t be easy. But some things are worth fighting for.”

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