India Culture, Business, Sports and Food. Get all the buzz in India now

“The king shall bestow on cultivators only such favour and remission as will tend to swell the treasury, and shall avoid such as deplete it.”

This dictum from Kautilya’s 4th century BC Arthashastra has circumscribed much of the thinking in today’s Budget making. Arthashastra has not been more fully read, nor the principles of modem public finance more fully understood.

Taxation has a legitimate basis, but the tax policies are set more by political economy constraints and less on rationality of their macro-economic and micro-economic effects. Hopefully, two recent research papers of National Bureau of Economic Research (NBER) would afford Budget makers another chance to consider the possible consequences of their deeds and misdeeds.

The first of these is by Martin Feldstein, who is currently the President of NBER, as also the Professor at the Harvard University. Feldstein says changes in tax rates does not just change realisation of capital gains, or portfolio composition between tax and tax-exempt financial instruments, but also alters supply of labour or the level of real income. It is important to understand the change in labour supply for it affects revenue estimation as well as work effort, occupational choices and if the fringe benefit tax (FBT) is not appropriately set, even the mix between taxable cash wages and lower-taxed FBT.

Alternatively, the FBT can reduce work efforts. There are several policy implications of what Feldstein has said for our Budget making. One simple thing, which needs to be considered, is that initial GDP forecast numbers can be taken as baseline numbers, on which the effects of proposed tax changes can be superimposed. The GDP number used in the Budget should not merely be a forecast based from CSO’s Advance Estimates, but should be set after careful deliberation of experts over what their tax proposals would do the growth rate. The FRBM targets would need to evolve in this milieu of dynamic relation between taxes and GDP. The impact of taxes on reducing work effort, saving and risk-taking need to be clearly understood as part of our Budget exercise.

The second of the NBER papers, deals with effect of corporate taxation on investment and enterprise. Rarely do as many as five economist co-author a research paper these days. But this one has two leading Harvard University professors - Andrei Shleifer and Tim Ganser, joining hands with three World Bank experts - Djankov, McLiesh and Ramalho to provide telling cross-country evidence on adverse impacts of corporate income tax on aggregate investment, foreign direct investment (FDI) and entrepreneurship.

They provide new data on effective corporate income tax rates in 85 countries in 2004 based on the survey conducted in January 2005 and 2006 jointly by the World Bank, Harvard University and PricewaterhouseCoopers.

Djiankov, et al (2008) findings show that a 10% increase in effective corporate tax rates reduces:

(i)    Reduces aggregate investment as % of GDP by 2 percentage points from an average of 21. 5 % for the sample countries,

(ii)   The PDI rate more sharply by 2.23 percentage points from an average of 3.36%,

(iii)            business density by 1.9 firms per 100 people (average of 5.0),

(iv)            Entry rate by 1.4 percentage points ‘(average of 8.0).

These results point to much larger adverse impacts of corporate income taxes on investment and enterprise than has been indicated so far in the literature.