From Financial Express October 18, 2012

The virtues of tax reform

Last month, I introduced the idea of virtuous growth, which includes the fairness objective of inclusive growth as well as an additional goal of building positive human values. I gave the example of local government reform in India as a practical step towards virtuous growth. Giving people more responsibility over public spending at the local level has the potential to increase the quality and level of civic engagement.

The issue of local government reform in India actually requires a rethink of India’s structure of tax authorities. Currently, the system in operation gives the Centre more tax authority than the states. Local governments have very little scope for taxing their constituents. These statements need to be qualified, of course. State and local governments in India actually tax less than their power to do so. One reason for this is that there is an elaborate system of sharing central tax revenue to the states, and state tax revenue to local governments. There is some justification for collecting taxes at higher levels of government—it can be more efficient, and less distorting of individual economic decisions. But transfers distort the revenue-raising decisions of the recipient state governments.

One way to get the efficiency advantages of higher-level government tax collection and the incentive advantages of a lower-level government tax authority is to allow piggybacking of lower-level governments on the higher-level government’s taxes. This has not really been done in India. The Constitution of India assigned different tax bases to different levels of government. For example, the Centre was given the authority to tax non-agricultural income, while the states were given the authority to tax agricultural income. This was one of the worst features of India’s tax system, since the states lacked the political will or capacity to tax farmers, even rich ones, and it also provided a route for disguising non-agricultural income and evading tax on that income.

In any case, the idea of different governments taxing the same base did take hold in India, using loopholes in the constitutional language. For example, state-level sales taxes and central excise duties were imposed on the same goods. This turned out to be very inefficient, since there was no coordination or transparency, and because one government’s taxes were imposed on values that included taxes by another government. The value added tax (VAT) system introduced in India a few years ago began to deal with this major inefficiency. The planned goods and services tax (GST) will extend the efficiency principles of the VAT to a broader array of commodities, and include services as well.

The details of the GST still need to be worked out and bargained over. Since it replaces existing taxes, the state governments, in particular, are worried about losing revenue as tax rates and tax shares are adjusted. The Centre needs to do more to sort out these problems and create a winning coalition for reform. One feature retained by the GST is likely to be fixed tax rates for the Central and state portions of the tax: the 13th Finance Commission follows the GST Task Force in recommending rates of 5% and 7%, respectively.

A piggybacking approach would allow states the possibility of increasing their individual rates up to some maximum level. One state might choose a rate of 8%, another of 7.5%, for its GST portion. The GST structure easily allows for this possibility. Piggybacking can go further. Urban and rural local governments could be allowed to add their own surcharges, up to some maximum. For example, one city might choose an additional 0.25%, another 0.5%. The point of these surcharges is that the lower-level government decides the rates. Surcharges can be determined by elected representatives or by referenda—the key idea is that, at the margin, the residents of a jurisdiction decide to tax themselves to finance public goods within their jurisdiction.

One could potentially extend piggybacking to the personal income tax, but the GST is an easier place to start, and the occasion of introducing something new like the GST can open the door for this additional innovation. The key idea is that piggybacking allows communities to make public revenue decisions at the margin, rather than relying only on transfers from a higher level government. Civic engagement should not be just about spending, but also about financing that spending. A modern information system for administering the GST would allow local surcharges to be collected and distributed. All of this is done in the US, for example.

One of the big problems in India’s governance is that individuals do not see the connection between the taxes they pay and the services the government provides. Individuals can see this connection better if they decide on taxing themselves at the margin, in small enough constituencies so that their decisions have weight. Piggybacking on a broad tax base avoids the problem of only being able to tax small activities, and reduces the cost of administering and collecting local taxes. It may even make it easier to get a consensus agreement on the GST, giving states more flexibility as well. Freedom combined with responsibility can be a virtue.
 

From Financial Express, September 19, 2012

Creating virtuous growth in India

In my last column, I introduced the concept of virtuous growth, which subsumes the idea of inclusive growth. Virtuous growth includes promoting fairness, but it also means avoiding societal change that corrupts and degrades positive human values. In this column, I want to spell out how India might create virtuous growth in practice. Virtue and inclusion, as characteristics of growth, may be the keys to sustaining that growth, besides having intrinsic societal value. However, it is important not to make the pursuit of virtue a pursuit of an unattainable utopia.

Michael Sandel, writing on the “Moral Limits of Markets,” sharply defines the conceptual issue for dealing with virtue. He quotes prominent American economist and policymaker Lawrence Summers: “We all have only so much altruism in us. Economists like me think of altruism as a valuable and rare good that needs conserving. Far better to conserve it by designing a system in which people’s wants will be satisfied by individuals being selfish, and saving that altruism for our families, our friends, and the many social problems in this world that markets cannot solve.” Instead, Sandel argues, virtuous attitudes are like muscles that grow stronger with exercise. In his view, altruism and similar virtues need to be pushed beyond family and friends, to the wider public sphere.
This gets to the heart of the Indian paradox. India’s leaders and its elite promoted a flawed implementation of virtuous growth after independence. Virtues such as fairness were sought to be achieved through legislation, in a society dominated by vertical and horizontal social cleavages. But India’s structures of governance became unintended arenas for the play of market forces, with government favours being bought and sold. Affirmative action made small inroads into lessening social divisions, but India’s masses have been seen as perennial children, to be managed without ever growing into well-functioning adults.

Like Lawrence Summers, India’s policymakers thought of virtues such as altruism to be in fixed supply. They thought of themselves as possessing most of this supply, so unlike Summers, they favoured paternalism rather than market allocation. Parallel manifestations of this attitude have been a high degree of government centralisation and extreme government control of the market.

The last point needs emphasising. Unlike the United States, where Michael Sandel can rightly bemoan the overreach of the market, India’s market system remains grossly underdeveloped. Economic reform in India has to correct that underdevelopment. India’s Dalits have perhaps been helped as much by market-oriented reform that has created more economic opportunities for them as by affirmative action. At the same time, the point of seeking virtuous growth is to avoid moving too much in the direction of a society where everything in life is bought and sold.

What can government properly do? Much of the inculcation of virtue is done through family and religion. But Sandel’s idea of promoting “reasoning about the common good” can be implemented in a couple of obvious spheres of action. One is civil society. India possesses a reasonably strong set of civil society institutions. These should be allowed to flourish, free of political interference and manipulation. These institutions, too, have a responsibility to seek change through reasoned debate and action, rather than agitation and knee-jerk reactions to the role of markets.

The largest arena for sowing the seeds of virtuous growth is at the level of local government. This is an ongoing process in India. Evidence is emerging that decentralisation in India has not only improved the allocation of some public goods, but has also led to more engagement, more public debate, and more transparency. The gains are still small, but they do suggest that the old fear that public virtue is limited at the local level no longer holds. If anything, problems continue to be witnessed with schemes that are decided in far-away Delhi, and trickle down to the village. It would be far better to give local governments more fiscal capacity and with it, more real decision-making power. The common good will be promoted by debates at the local level on the best means of doing so, when the debaters know that they control the outcomes.

This does not mean that virtue will emerge spontaneously. Frameworks of participation have to be structured to be fair and inclusive—the reservations for women at the local government level are a good example. Just as when James Madison wrote, while debating the formation of structures of governance for the US, “men are not angels.” And neither are women. Monitoring, accountability and checks and balances are still needed.

My conclusion, then, is a modest one. A start to implementing virtuous growth can be made by decentralising more fiscal capacity to the local level. To do this in a politically feasible way will also require fiscal decentralisation to the states, of revenue as well as expenditure authority. The Centre has to structure this decentralisation to protect horizontal equity. The current system of intergovernmental transfers does that in a very imperfect and limited way. Fixing this system will require a strong effort, so even this modest goal will not be easy. But exercising virtue often is not the easy thing to do.