Shibboleths of the 'ideal' tax system

The time-hallowed principle of focusing on direct taxes is worth questioning

The late Chinese bossman, Deng Xiaoping, the man chiefly responsible for the country’s rise to economic success, is credited with the aphorism that it does not matter what the colour of the cat is as long as it catches mice. The importance of this practical idea — that getting things done is more important than theories and ideologies that underpin them — is particularly relevant at a time when all the things we took for granted in the 20th century start crumbling under the weight of their own contradictions. Belief in free trade, globalisation, electoral democracy, capitalism, communism or Keynesian macroeconomics has never been lower. Not because ideologies have shifted, but because the principles underlying them have proved to be flawed. They are not working.

This is the underlying point in the Hegelian thesis that every proposition contains within it the seeds of its own destruction. It means all ideologies are ultimately expendable unless they keep evolving. Marx’s predictions, or, for that matter, classical economists’ understanding of how markets and capitalism work, have failed primarily because they expected human and economic progress to move in a linear fashion, and not in cycles, as Hegel’s proposition or karma theory suggest.

We have entered a post-ideological world, where the dominant guiding principle should be about what works in which culture, and not mindless application of “universal” principles that have begun to falter even in the soils they were originally nurtured. Capitalism is under attack in western Europe and America, and communism has collapsed in the regions of its dominance in the last century. One can be certain that authoritarian capitalism of the Chinese variety will also have a sell-by date.

In this series, I will outline ideas that have outgrown the ideologies that nurtured them. I propose to start with taxation, currently a hot topic as the United States now believes that all companies must pay a minimum amount of tax (currently deemed to be around 15 per cent), and most rich nations seem to agree. While it is not clear whether a country like India, which has only recently cut corporate taxes (in 2019), will benefit significantly, we can assume that the main reason why the US is proposing minimum taxes is because it expects to gain the most.

Uncle Sam is never about charity. He has espoused ideas as universal only as long as they worked for the US. He was a great propagandist for capitalism and free markets when he saw benefit in them; now he has changed tack and wants to make sure that the capital which had flown out of the US to low-tax jurisdictions comes back. The US preached the virtues of technology when it was the top dog; now that its own technology giants have become more powerful than itself, Uncle Sam wants to rein them at home (through anti-trust suits) even while protecting US interests elsewhere. In India, the US administration will be asking for a free run for the Googles, Apples, Microsofts and Twitters of the world. It will oppose data localisation or equalisation taxes, and even back its social media giants to follow US law rather than local ones. The US has no problems with tech colonisation elsewhere, as long as it serves US interests.

Illustration: Binay Sinha

India should have been in no rush to endorse the US’s minimum tax proposals (but we have already signed on for fear of being left out in the cold), nor should it buy some of the shibboleths about long-term tax principles. At the very least, to protect its own interests, it should insist that actual tax flows from global companies must be monitored to check if the minimum tax proposal is beneficial to all. And the one thing we have forgotten in all this enthusiasm about adding $100-150 billion to the global tax kitty is that corporations are not dumb. They will evolve, mutate, merge, demerge to avoid at least some of the taxes that they will be asked to pay in future.

Two time-hallowed tax principles are worth questioning: One, that it is good to raise the tax-GDP ratio in general; second, one must not raise too much from indirect taxes, which are “regressive”, and instead focus on direct taxes which are “progressive”.

In the context of the recent provisional data put out by the Office of the Controller General of Accounts, which showed that the Centre’s collection of indirect taxes exceeded collections from direct taxes in 2020-21, there has been much hand-wringing among economists about regressive taxes overtaking progressive ones.

This reasoning is flawed in the Indian context, for our goods and services tax (GST) is actually progressive, and these very same economists want GST to ultimately become a single rate of tax. In short, to make compliance easier, the advice is that GST must become regressive in future. We need to also ask: If direct taxes are indeed the way to go, how are you going to tax the rural rich who derive all their incomes from negatively-taxed agriculture? Isn’t indirect tax the best way to ensure they pay some tax at least?

On the other hand, it is not always true that direct taxes have to be  progressive. A state that levies a flat rate of income tax will be regressive, even as a tax rate that rises with income levels is progressive. Whether a tax rate is regressive or progressive depends not on the tax itself, but the rate structure. The tradeoff happens because one sacrifices equity for simplicity, or vice-versa.

It is not necessary that a single tax rate, whether for indirect taxes or direct, will be loaded against the poor and less fortunate. All we need to do to retain simplicity is to exempt more products consumed by the poor and raise threshold levels for income taxes, and equity and simplicity can both be achieved.

As for the tax-GDP ratio, the less said the better. This ratio is the result of not just tax policies, but levels of compliance and levels of economic activity achieved. It is a derivative number, and should not be a focus area for action. The focus should be on having a rate where compliance is maximised, and economic activity is least impeded. It is time we stopped obsessing with the wrong goals.

In a diverse country like India, where taxpayers and social security beneficiaries may come from different communities, the willingness to comply will always be low. Hence the need for tax terrorism, which then nudges high net worth individuals to move elsewhere. Indirect taxes are the right way to make people pay more taxes, without anybody fretting about who is paying them or benefiting from them. High direct tax rates are wrong for us; bearable indirect taxes, with near zero rates for wage-goods, are the way to go for India. Like Deng implied, let’s not worry about the colour of the tax cat right now as long as it brings in the moolah.

The writer is editorial director, Swarajya magazine