Tax mix and rates in a low interest environment will change

When supply goes up, prices usually tend to go down, provided demand remains constant or declines. By and large, the same thing happens to money also.

That’s why we have seen interest rates gradually tending down for the last 30 years. The supply of money has been increasing. In some countries the rates have gone to zero or almost zero.

This much is known. But what effect does this have on fiscal policy which caused the supply of money to rise in the first place?

Before answering that, let’s get a tricky question out of the way: what exactly is meant by ‘low’ interest rates in India ?

This is important because low inflation means at its best zero inflation, which is good. But low interest rates don’t mean a zero rate because that would be bad.

In any case there was a time when 15 per cent was considered low in India, down from 18-20 per cent. Now, however, it is around 5 per cent and it is likely to go down further.

But it’s difficult to predict to what level it will go down and by when and why. I would say by 2025 we will be at 3-4 per cent. I could be wrong. 

The likely effects of ‘low’

Now, let’s see what the latest economics research has to say about the effects of low interest rates on fiscal, or more precisely, tax policy.

Two well-known American economists, Alan J. Auerbach and William Gale Have uploaded a paper called Tax Policy Design with Low Interest Rates. (NBER Working Paper No. 29352).

In it they say that “low interest rates reduce the differences between consumption and income taxes; make wealth taxes less efficient relative to capital income taxes, at given rates of tax; reduce the value of firm-level investment incentives, and substantially raise the valuation of benefits of carbon abatement policies relative to their costs.”

To me it appears that the key insight applicable to India is the idea of deadweight loss. This is the loss incurred when governments will spend (and therefore tax for) on poverty alleviation and climate change policies. Generally, tax rates are likely to increase but by how much depends on the local circumstances.

The authors say “that if low interest rates are expected to persist, there are important implications for the design of tax policy as well…in the presence of low interest rates, subsidies to saving and investment are less potent; the wealth tax is bigger and more distortionary relative to an income tax, for given tax rates; and investments with back-loaded benefits (most prominently carbon taxes) are more valuable.”

In other words climate related fiscal policy could replace poverty alleviation related fiscal policy. Not in India, I think. Here the poor have a lot of votes.

The point about climate spending is that taxes to fund it are paid now but social benefits accrue maybe three decades later. It’s exactly the same as spending on education and health. Pay now, consume later.

The paper is full of not-easy-to-follow technical discussions on a variety of related topics. But all of it points in the direction of changing the tax mix and, of course, the tax rates.

When you look at it closely, this is Kaldorian in intent. In 1956 Nicholas Kaldor, the Cambridge economist had suggested similar tax policies for India for exactly the same objectives.

Being a tax policy man, however, he had not approached the problem from the monetary angle. His were more plain, vanilla socialist prescriptions — Robin Hood stuff. 

These conclusions could have important implications for India. The finance ministry should pay heed not only because it is constantly doing tax jugaad but also because it will be swimming against the current if it neglects to investigate these findings further. It should ask the NIPFP to do so.