Devangshu Datta: The FM's trump card

WORM'S EYE VIEW/ A cashless economy will ensure better taxation of services

In a feudal society, the peasant is the prime target of taxation. This is more a matter of administrative convenience than any particular animus against the peasant. The peasant is a sitting duck; he's tied to the land. Come harvest time, the revenue officers arrive with musclemen in tow and take what they want.

When a society evolves beyond the feudal, patterns of taxation also change. The peasant and his younger brother, the worker who has migrated to the city in search of work, end up in control at some stage.

In a democratic system, they get the vote. If there's a revolution, they chase the outnumbered capitalists and aristos down the streets "with dripping knives", if one may borrow P G Wodehouse's evocative phrase.

Once the peasant is in control, he stops paying taxes and starts giving himself subsidies instead. Over time, the state develops a better system of tracking income and starts putting the screws on the merchant, the apothecary, the factory-owner and the clerk.

This works fine from the point of view of the peasant so long as the economy consists mainly of agro and manufacturing activities. The peasant and his brother, the worker, remain a numeric majority, ensuring that they retain control of the state machinery.

Income from the manufacturing sector is easy to track, and enough revenue can be raised to ensure that things don't go to hell in a handbasket.

It's at the next stage that problems arise. Once an economy is sophisticated enough to contain a large component of service-sector activity, things change.

Manufacturing no longer generates enough revenues. Service income is too slippery to be taxed with certainty. And, of course, since the peasant retains control of the state machinery, agriculture remains a holy cow.

Even in the most prosperous parts of the world "" the Euro-13, Japan and the US "" agriculture continues to swallow subsidies while staying outside the tax net.

This is an anachronism; farmers form small proportions of the general population of these countries and agriculture is a tiny part of GDP. There is no rational reason why it should be subsidised except that removal of subsidies causes political upheavals.

In India, the rural population remains a substantial majority, although agriculture is third on the list of GDP components behind services and manufacturing.

The trend of urbanisation and fast-growing services suggests that this won't be true for much longer. In perhaps 15 years, fewer Indians will work on the land compared to their brethren in call centres and auto-repair shops. But the Euro-US experience suggests that agriculture will continue to draw subsidies long beyond that inflexion point, whenever it occurs.

That's political reality. So, how do we get around it? Most developed countries have worked out ways and means to track and tax services "" thus ensuring the biggest, highest-growth component of the economy carries the largest revenue burden.

There are many ways in which such taxation systems evolved but they all have one thing in common: a cashless economy. Be it the Euro or the US, most legal transactions are done by cheque or card inside an intimately-linked financial system. One could state this as an axiom: until you have a cashless economy, you cannot efficiently tax services.

Creating a cashless economy ought to be a major priority for the ministry of finance. Instead of hiking service tax levels and drawing in more sectors piecemeal, someone (no prizes for guessing who!) needs to figure out how to make the transition to a cashless economy. In the Indian context, credit cards and cheques don't work "" these carry massive default risks because of the messy legal system.

The solution is the debit card "" this draws on owned funds with zero-default risk. In order to improve tax as a percentage of GDP, the state must try and raise debit card penetration levels to the point where every adult uses one except when he's indulging in nefarious activities. A truly visionary finance minister would work to achieve this goal.