Can the Modi government shed its Nehruvian approach to taxation?

The Budget must focus on the income effect by taking steps to put more money in the pockets of those who are still earning.

As January approaches, two things are happening that are important for the economy. One is the Omicron effect. The other is the Budget effect.

On the face of it the two seem unrelated. But in fact they are intimately related because while one is causing the income effect on demand, the other causes the price effect on it.

The income effect on demand is simply the effect on demand of a change in real incomes. The price effect is the effect on demand of change in prices.

Omicron, unless controlled, will cause the income effect. If incomes get depressed, demand will decline, too.

The Budget, in the meantime, if not sensitive to economics, will cause the price effect — as it has been doing since 1957 when indirect taxes were first raised steeply. Together, these two effects could severely damage the recovery now underway.

It is important, in this context, to recall that the shock to the formal and near-formal sectors of the economy in 2020, despite the income effect, was rendered less severe by the price effect because prices stayed subdued. So lower incomes didn’t have the same effect as they would have had if prices had been rising too.

But now, while the risk to incomes remains, the risk to prices is very real. They are rising far too quickly for comfort and thus tending to depress demand even further.

High prices and low incomes are a recipe for a further slowdown. This is a complete throwback to the late 1970s and early 1980s when the same features had hobbled the economy, amongst other things.

Today taxes take away more than half the incomes of people and rising prices further erode the spending power of whatever little remains. In fact things are worse now because the share of overheads in household incomes — school

fees, loans, insurance, TV, mobile phones, for example — has increased.

Discretionary expenditure, as result, is no more than 3-5 per cent of nominal income.

That’s simply not enough to revive demand on a sustainable basis, especially if every now and then Coronavirus (Covid-19) is going to reduce gross earnings in the economy.

The question today, therefore, is what can the Budget do to mitigate the price and income effects? Should it focus on the former or the latter?

And the answer is it must focus on the income effect by taking steps to put more money in the pockets of those who are still earning. With imported inflation via higher oil prices and a depreciated rupee, and the explosion of cold storages that allow the slowing down releases of perishable agricultural produce, the government has little control over inflation.

That is why the government must lower prices by persuading the states to reduce and reform GST rates and the Budget must raise disposable incomes by lowering income taxes. The two need to be done simultaneously.

But the annoying part is that the finance ministry knows this. The problem, however, is that politics requires massive income transfers to the poor who, by definition, have no impact on the demand for anything except food prices —

which are rising sharply.

This has been a constant feature of all the Modi budgets since 2015. They have operated at cross-purposes by supporting the incomes of the poor, while lowering the incomes of those who are not poor. The result is higher food

prices and lower demand for formal sector products.

It was in 1997 that the government lowered income taxes very sharply. Those rates have remained since then. The time has now come to have a rate of 20 per cent for those who earn up to one crore a year and 40 per cent for those

who earn more.

The effect on both government revenue and aggregate demand will be magical. But can the Modi government shed its Nehruvian approach to taxation?