Business Today

Thank you, Mr Laffer

The new tax code proves the government is now convinced that the only way it can earn more is by taking less from people.

Puja Mehra        Print Edition: September 6, 2009

The finance ministers of the late 1960s and early 1970s must be turning in their grave. It was then that India had a peak income tax rate of 97.5%—beyond a level, for every 100 rupee you earned government took away Rs 97.5 as income tax. Perhaps American economist Arthur Laffer, who studied the inverse relationship between tax rates and tax collections, wasn’t even known as an economist then.

But Finance Minister Pranab Mukherjee's proposed new tax code proves that he is far more convinced with Laffer than predecessors from his own party. Since 1992-93, India has progressively reduced the burden of taxes—through a mix of reduced rates, restructured slabs and higher thresholds below which incomes remain tax-free. In doing so, successive finance ministers have faced severe criticism.

Saving for gambling?
Americans love to gamble. In 2007, the latest year for which final numbers are available. US residents spent $92.3 billion on legalised gambling, according to Christiansen Capital Advisors. In the same year, they saved a mere $57.4 billion, the U.S. Bureau of Economic Analysis (BEA) notes. Things, however, might be changing thanks to the slowdown. The BEA says personal savings has risen to a 6.9% annual rate for 2008-2009, up from 2006-07, when households were spending 99.6 cent of every dollar they earned.

Finance Minister in the first UPA government and current Union Home Minister P. Chidambaram gave away the boldest rate cuts in the 1997 Budget, but was widely condemned for “serving the interests of the rich” by his own party men. The easing incidence, however, lifted the overall tax compliance as tax evaders who used to find rates prohibitive began to pay up.

Today, income tax collections are up from Rs 16,656 crore in 1991-92 to Rs 1,22,600 crore in 2008-09 (estimate), though not all of the seven-fold surge has come from improved compliance. High economic growth and the slow-yet-steady rise in cost of evasion have helped the taxman, too. The personal income tax-GDP ratio itself has nearly trebled to 2.6 per cent since 1991-92. It is this trade-off between tax revenues and tax rates that economists call the Laffer Curve.

Laffer explains the basic idea behind the relationship between tax rates and tax revenues by arguing that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect simply means if tax rates are lowered, tax revenues will diminish. The reverse is true for an increase in tax rates.

The economic effect, however, recognises the positive impact that lower tax rates have on work, output, and employment—and thereby the tax base—by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalising participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.

Between 1979 and 2002, more than 40 other countries, including the UK, Belgium, Denmark, Finland, France, Germany, Norway, and Sweden, cut their top rates of personal income tax successfully. Finance Minister Pranab Mukherjee’s endorsement of the Laffer Curve principle is even more gladdening since he also held the portfolio in the 1980s in the Indira Gandhi Cabinet, presiding over perhaps the most regressive tax regime.

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