Cake or taxes?

A day after the Union Budget, while speaking in Varanasi to an audience of BJP workers, Prime Minister Narendra Modi was emphatic when he said “the size of the cake matters”. In a country whose political economy has traditionally been more concerned about slicing and distributing the cake it was wonderful to hear a Prime Minister publicly accord priority to growth. 

The comment was made in the context of skepticism expressed by some about the government’s ambition of a $5 trillion economy by 2024. It is a comment which also needs to be made in the context of India’s tax policies. Just a day earlier, Finance Minister Nirmala Sitharaman had announced an increase in tax rates on the “super rich”. Also, she had not extended the benefit of a lower corporate tax rate of 25 per cent to large companies, that is, those with turnover greater than Rs 400 crore. It is likely that the government was largely guided by arithmetic in its tax decisions. It needed to meet its fiscal target of 3.3 per cent of GDP. And it had already committed spending, both investment and redistribution. Revenue had to be shored up. More taxes on the rich makes for a good political argument and excellent political optics because they can obviously afford to pay more.

Unfortunately, the arithmetic of Budget revenue targets is an anathema to the Prime Minister’s philosophy of expanding the size of the cake. The super-rich — entrepreneurs, CEOs, CFOs — are generators of wealth. They already contribute their fair share of taxes while millions of others evade or avoid. By imposing further taxes on this group, the government is only penalising wealth creation and honest paying of taxes. The super-rich are also the most foot loose — they can shift their residence and even business to an overseas jurisdiction with lower tax rates. India cannot afford a flight of its best entrepreneurs, managers and capital. It is happening.

illustration by binay sinha
Large companies not only create wealth but also good jobs. In India, micro, small and medium enterprises are often trumpeted as the biggest job creators, which may be true, but these are usually low paid, low quality, informal sector jobs. In fact, the biggest chunk of the MSME sector in India is micro, not small or medium. India’s challenge is to create good jobs, with high wages, benefits and security which will only be provided by large companies and perhaps medium-sized companies, certainly not micro enterprises. 

Also, scale matters if companies have to compete in global markets or in domestic markets against foreign competition. India is absent from global and regional value chains because it doesn’t have enough firms that have the necessary scale to be efficient players in such value chains. For the sake of a competitive industrial sector, tax policy should incentivise firms to get bigger, not to remain micro and small. The current regime, by giving concessions to firms with a turnover of less than Rs 400 crore, incentives them to not grow beyond that.

Of course, even in the event that firms do become large, they are still not likely to be globally competitive because they have to pay a higher top tax rate than in competitor countries, particularly in East Asia. The emergence of a competitive large industrial sector is the only route to fast growing economy which creates productive jobs for an aspirational population.    

Now that the Modi government has stated an ambitious goal of a $5 trillion economy — and we know the Prime Minister is determined to achieve targets — its tax policies must focus primarily on increasing the size of the cake. Obviously, this means that both income and corporate taxes should be lower. For individuals, the rich will still pay a higher rate, but ideally the top rate should be no higher than the top corporate tax rate which is 30 per cent now, but which should be brought down to 25 per cent in the next Budget for all firms. Surcharges must be abolished.

The new philosophy should also make clear to the tax administration that it must not try to meet its targets by trying to (unfairly) squeeze those who already pay taxes. The harassment of taxpayers (both individual and corporate) is a deterrent to investment as much as the high rates are. Instead, the tax administration should be instructed at expanding the tax base and brining into the net those who have stayed away. One way to do this is to end exemptions of all kinds.

In the medium term, maximum buoyancy to tax collection will be provided by a robust growth rate which in turn requires massive investment by the rich (individuals and firms). The size of the cake cannot increase if the makers of the cake are squeezed into discomfort in the short term.

The author is chief economist, Vedanta