27 February 2013, 12:31 PM IST
The FM should mind the law of unintended consequences when levying new taxes
With his forthcoming budget, finance minister P Chidambaram could add a few noteworthy examples to the field of academic investigation called unintended consequences. It is a field littered with dead bodies, much mayhem and a few benign developments.
Prohibition in the 1920s in the US led to the growth of organised crime, irrigation to increase crop yields in traditionally dry areas led to the spread of mosquitoes and the deadly diseases they carry, legalisation of abortion in the US led to a drop in the crime rate. P Chidambaram can, in 2013, create new Haji Mastansand spread the growth of black money, with a few taxes he seems to favour.
One, he could increase the import duty on gold, already a steep 6%. Already, official gold imports are reportedly down by 20 odd tonnes a month, thanks to the enhanced import duty. The higher the import duty, the greater the incentive to smuggle large quantities of gold.
Largescale smuggling will create new crime lords like Haji Mastan and Dawood Ibrahim. The proceeds of crime would once again dominate the industries they have traditionally tainted, such as films and real estate.
The policy alternative is to allow the financial marketsto function well and create financial instruments that hedge against inflation at least as well as gold does.Gold prices are on a downward trend. This would not increase the demand for gold, as many predict. What has been causing distress on the current account is the incremental demand for gold that comes from the desire to protect savings from erosion by inflation. When gold prices show a sign of falling, that might boost consumption demand but would certainly dampen the demand for gold as a stable store of value. Lowering the import duty on gold to a nominal 1% would make sense, from this point of view.
Two, the finance minister could, in theory, levy a special, higher rate of income tax on the super-rich. This would be entirely counterproductive. Tax compliance in a country like India, where people do not see tax through the prism of ethics, is a question of how the cost of compliance compares with the cost of evasion. A likely prison term greatly increases the cost of evasion. But since that is not on the cards, increasing the cost of compliance by jacking up the marginal rate of income tax only serves to increase the incentive to evade or avoid compliance. There would be more black money in the system. The super rich can employ better tax planning to avoid taxes and end up paying even a lower proportion of taxes than they do at present.
The policy alternative is to widen the tax base and lower rates of tax. A swift transition to the Goods andServices Tax would generate countless audit trails to incomes generated from value addition in manufacturing and provision of services and help the tax administration collect its dues.
Three, the FM could extend the reach of financial transaction taxes to commodity futures. Commodity exchanges have been doing the rounds of newspaper offices and chambers of commerce and industry trying to ward off a transaction tax on commodity trades. They fear that such a tax, even if restricted to non-agricultural commodities, would drive the entire market underground and kill off important commodity benchmarks being developed in this part of the world. These fears are entirely justified.
Besides, financial transaction taxes, including the existing one on securities, are bad in principle. In our country, financial markets are little understood, even by normally intelligent people. Most people consider speculation an unethical activity, one that deserves to be penalised. The same people would consider hedging against risk, buying insurance, to be both prudent and virtuous. This is downright silly. Virtuous hedging is possible only because there are 'scheming' speculators who trust their expertise to figure that the eventuality the hedger wants to escape would not happen and so is willing to take on the risk of that eventuality from the hedger.
The modern financial system allocates not only funds but also risk. It allocates risk across society, to its maximum risk-bearing capacity. The lower the risk, the lower the cost of capital. So, the functioning of the modern financial system, with its host of financial instruments that permit hedging and speculation, serves to lower the cost of capital across the board. The biggest beneficiaries are those at the bottom of the foodchain, the small and medium enterprises, who bear the highest rates of interest in any given spread of rates. Taxes on financial transactions impede this process of risk diversification and raise the cost of capital. The gain to the exchequer of a few thousand crore of direct revenue is more than offset by the loss to the economy as a whole and the resultant indirect loss to the exchequer.
The superior policy alternative is to scrap all financial transaction taxes and bring back the tax treatment of savings and capital gains P Chidambaram had himself proposed in the original Direct Taxes Code.
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